Buying an asset is only half of the investing game – you also need to know how to sell well in order to get out ahead.
In this guide, I’m going to tell you all about exit liquidity: the ability to cash out your crypto investments when the time is right. This requires careful planning and understanding of market conditions to protect and squeeze the most juice out of your investment.
What is Exit Liquidity and Why Should You Care?
Exit liquidity is an especially important concept in emerging markets like the crypto world. These markets sometimes don’t have enough buyers and sellers at any one moment to absorb all of the supply (or demand) that early investors need.
To put it simply, exit liquidity refers to how easily and quickly you can sell your assets.
If exit liquidity is high, we can sell our crypto at around market prices. If exit liquidity is low, we lack the ability to do so. Bad exit liquidity can mean that we sometimes can’t exit a trade at decent prices, cutting into profits or sometimes even leaving us without a buyer at all.
Quite often, the retail investors (average Joe investors) are used as exit liquidity for the “smart money” investors. That is, the pros, such as venture capital firms and institutions.
To avoid the exit liquidity trap, you need to keep a clear strategy and consider all of the risks involved before entering into a position.
Read on below to explore what we should pay attention to, to ensure we get the best exit liquidity possible on any investment or trade.
How Can Exit Liquidity Save You Thousands?
Good exit liquidity can save you a lot of money for one simple reason:
Being able to sell your entire investment to many buyers at a good price is much more profitable than selling it to a few buyers at a bad price.
Therefore, planning an investment for good exit liquidity is about as important as it gets.
Here are two examples of cases where poor exit liquidity could mess up your investment:
1. NFT assets
Moonbirds once sold for an average of 31 Ether (ETH) for each NFT in the collection – at the time of writing, they’re going for a little more than 0.53 ETH.
Selling an NFT for a decent price is often easier said than done. Why? Well, there are offers of up to 0.47 ETH on some of the collection, which is already a 10% step below the lowest asking price. But that’s not where the trouble ends.
That 0.47 offer isn’t necessarily for any Moonbird in the collection, it’s for a specific one. That means that you can’t sell just any Moonbird for that price. You need to sell the exact moonbird that the buyer wants.
A bit of a pain in the butt – especially in an NFT bear market.
2. Large position sizes
For large-sized trades, liquidity is everything. Take, for example, this trade on Uniswap competitor, SushiSwap:
If I want to sell 1,000 ETH for SUSHI (wishful thinking, I know), I will lose more than 50% of the value of that ETH since the market between those two tokens has poor liquidity.
Of course, this size of trade may be rare due to its sheer value. But for smaller and newer coins, this is just a normal scenario. Just a $1,000 trade could be too much for the liquidity of the market to handle in one go.
When You Should Pay Extra Attention To Exit Liquidity
Paying extra attention to exit liquidity pays off in a whole range of different scenarios. Here’s when you definitely want to keep an eye on liquidity:
Large trade VS market cap
If you’re reading this, you’re most likely not trading millions of dollars in size just yet. However, in crypto projects and emerging markets, it’s still possible to trade large amounts relative to the total market cap of the asset.
What does this mean?
Well, if you’re trading an asset like new crypto projects or a penny stock. A thousand-dollar investment may actually be quite a large percentage of the asset or company’s total value.
This means that no matter how big the asset grows, the percentage you want to sell may have a significant impact on the market.
For example, buying $35,000 worth of Dogecoin in 2013 was equal to 1% of the supply. Dogecoin has grown exponentially since then. If you held onto it and tried to sell it now, you’d still wipe out all of the sell orders on the biggest exchange, Binance – because you’d still be holding more coins than the market could absorb. Not to mention getting a really bad price for them.
Trying to sell 1% of the Doge supply on Binance would use up all existing sell orders – meaning you could only sell a tiny portion.
Liquidity and volume is low
Some assets simply don’t have much buying and selling activity, known as low liquidity.
Low liquidity could come from a variety of factors. A lack of popularity, a lack of exposure, people preferring to hold or use the asset rather than trade it. Even in bearish market conditions where people are simply too scared to buy.
Volume is a good indicator of this – the amount of buying and selling that’s taken place on an asset.
The asset class is illiquid
Some assets are just known for having poor liquidity, or what we call being “illiquid”. In general, this means that there is a lack of buyers or sellers in the market for that type of asset. Other times, the buying and selling process is simply just slow.
This applies best to asset classes of non-fungible goods, such as houses or NFTs.
These assets aren’t easily interchangeable – in other words, no two houses are exactly the same. They may be similar, but they can’t all be treated exactly the same.
Because of this, a house needs to be examined individually. This makes buying and selling houses a slow process, not to mention having fewer buyers and sellers than lower-cost items.
Similarly, NFTs can’t always be aggregated together and treated the same, even if they’re from the same collection.
Volatility is high
High volatility is when the price of an asset fluctuates a lot, especially in a short amount of time. A classic example is crypto – prices can simply be all over the place.
When volatility is high, buy and sell orders are taken out rapidly by many investors, meaning that there might not be enough of them to fill their place. No orders means no liquidity.
Pump and dumps
The notorious pump-and-dump scheme is when a group participates in coordinated buying, to artificially pump an asset’s price.
This is done only to cash-out on new investors, who fall prey to trying to ride the wave of the sudden price increase. The early investors then use this surge of high liquidity to sell worthless coins to other investors (“dumping”) all at once.
Since the buying pressure was never organic to begin with, it often results in few real orders to sell into when you want to exit.
What Affects Exit Liquidity in Investments?
So, what else do we need to think about that might affect the liquidity of our investments?
1. Market conditions
Market conditions such as how much trading is happening and the overall mood of the market strongly affect when and how investors can sell their investments. For example, the ease of selling shares of ETFs depends on the demand for the assets they are made up of.
2. Economic factors
Economic factors like financial crises can make it hard for markets to function smoothly, affecting investment values. This happens because banks and businesses hold onto their money tightly, leading to fewer transactions and reduced investment growth.
3. Tax considerations
Tax considerations require careful planning to minimize the impact of taxes on profits from selling investments. Effective strategies can include balancing gains and losses or adjusting the timing of income to benefit from lower taxes.
4. Regulations
Changes in regulations can greatly influence how easily early investors (especially venture capital firms) can sell their investments. This may affect confidence in the financial markets, including the stock market and cryptocurrencies.
5. Liquidity events
Liquidity events are moments in a market when there is a large change in liquidity that may affect investors.
A liquidity event could be triggered by situations that raise capital, such as an initial public offering (or initial coin offerings, for crypto) by a private company. An acquisition or merger with a new company can also be considered a liquidity event.
6. Global perspective
Keeping a global view is important for managing investment exits well, especially considering how central the US dollar is to international trading and how changes in its use by central banks can affect market liquidity.
How to Assess Exit Liquidity Before Investing?
Here’s a quick checklist that you can use to analyze the potential for good exit liquidity in your investments.
☐ Does the asset have a large market cap?
☐ Does the asset have large daily trading volumes?
☐ Is there a healthy supply of the asset circulating?
☐ Is the asset in a bull market?
☐ Is the asset likely to remain popular
☐ Are there events coming that will draw more buyers into the market?
☐ Are there regulations that influence how easily investors can sell that particular asset?
The more of these that you can answer “yes” to, the better!
What Are Effective Exit Strategies for Investors?
Whether you’re looking to enter an investment position, or you’re in one already, there are a few risk management strategies you can take on board for the best exit possible.
- Partial profits: If possible, sell off your position in parts for a smooth exit – rather than all at once. This gives time for buyers to re-enter the market at current prices, rather than clearing out all existing orders in one go. This especially applies to large positions.
- Sell into strength: Exit your position when the market is still trending up, rather than when it’s crashing. You may miss some further room for gain, but at least you’ll be able to find a buyer at all.
- Plan your exit: Look into the future where you can, with thorough research. Are there certain news or regulatory events that will temporarily send more buyers into the market? Time your selling to coincide with these moments.
- Cut your losses: Have a minimum selling price in mind. If possible, set a stop-loss order around this price to make sure you can offload your position.
How Does Exit Liquidity Affect Different Asset Classes?
Exit liquidity affects different types of investments in unique ways.
For stock market instruments like ETFs, it means you can sell your shares quickly without causing the price to drop significantly. This smooth process is possible because the system adjusts the number of shares to match what people want to buy.
In the world of crypto, especially tokens that don’t have any real underlying value, exit liquidity lets early investors sell off their holdings for a profit, driven by other people’s excitement and the hope for high returns. However, crypto can be very risky, and the prices can swing wildly, potentially leading to big losses.
With venture capitalists’ investments, there are often set times when early investors can’t sell their shares, known as lock-up periods. You might have to pay extra fees if you sell shares during these times.
Frequently Asked Questions
Liquidity means the ability to convert existing shareholders' ownership into cash or liquid assets. This allows early investors to cash out the value of their investment.
Liquidity refers to the ease and speed with which an asset can be converted into cash without losing value. It is important for a company as it indicates its flexibility in meeting financial obligations.
Exit liquidity is the ease and speed of selling assets for cash without significant loss in value. It is important for investors to consider exit liquidity when seeking investment opportunities.
The most effective exit strategy for investors includes establishing plans for liquidity events by using stop-loss orders and accounting for token unlocks, venture capitalists’ vesting schedules and more. These strategies help to secure returns on investments and minimize potential losses.
