On a decentralised exchange there is no order book of buyers and sellers. Trades happen against a pool: a pair of tokens deposited by liquidity providers. The value in that pool is the liquidity.
Why depth changes your price
A trade changes the ratio of the two tokens in the pool, and the price follows the ratio. In a deep pool, your trade is a small ripple. In a shallow pool, the same trade is a wave, so you pay noticeably more when buying and receive noticeably less when selling.
Liquidity is not market cap
A token can show a market cap of ten million dollars while its pool holds twenty thousand. The market cap is a price multiplied by supply, and the price came from tiny trades. You cannot sell ten million dollars of tokens into a twenty thousand dollar pool. Always compare the two.
What to look at
- Total liquidity in dollars, and how it compares with the size you want to trade.
- Volume against liquidity. Very high volume on thin liquidity can mean wash trading or a heavily contested token.
- Who provided it. If one wallet supplied nearly everything, that wallet can withdraw nearly everything.
- Whether it is locked, and for how long.