How is liquidity calculated?

Liquidity is calculated by taking a slice of the order book within a given percent of the price. For example, if the current price is $1,000, 1% liquidity would include bids > $990 and asks < $1,010. For each bid and ask within range, the order value is calculated by multiplying the price by the quantity. These values are then summed up. You can also think of it as the total market order amount it will take to push the price down (or up) by 1%.

Why is liquidity important?

Liquidity tells large traders if they can enter the market without paying a large slippage cost. Along with other metrics, it can also be used to measure general investor interest in a coin.

Why not use market cap?

Market cap assumes you can trade all units at the current market price. However, this is impossible since a large order would immediately eat through the order book and send the price plummeting (in case of a sell) or to soaring (in case of a buy). Further, the market cap can be easily gamed by coins with a pre-mine, where a large portion of the supply is held by insiders and not available on the market. Liquidity is a much better measure because it is harder to game. When you place a limit order very close to the price, there is a real possibility it will get executed. It forces someone attempting to manipulate the market to have skin in the game.

Why only look at a small slice (1%) of an order book?

The further the limit price on the order is away from the market price, the less likely it is to get executed. Looking at the entire order book would make this metric easier to game as somebody could just put up large orders at $0.01 or $999,999.99 which have almost no chance of getting executed. Even orders 5% away could be moved automatically by a bot if the price starts getting too close to their limit. A 1% order has a very high probability of getting executed instantly, especially in a volatile market like this.