While entering the world of trading, some important principles dictate financial markets. Three of the most important concepts are Risk, return, and market liquidity. Stock Market Liquidity is an aspect that can influence all types of assets; however large-cap stocks often represent the most liquid type of assets. It affects all sides of your investment process, from the flexibility of your trades to the productivity of your assets.

Since liquidity is critical, it is crucial to explain what market liquidity is and how to determine if a market is liquid or illiquid. Depending on how ‘liquid’ the stock market is, one may have to hold on to their shares for longer before selling them. To answer this question, it is important first to understand what the term liquidity entails.

What is Liquidity?

Liquidity is defined as the ability of an asset, whether it is real estate, stocks or anything else, to be bought or sold easily in the market without necessarily affecting the value of the asset. Liquidity is high when buyers and sellers are in a balance, thus making transactions occur easily. On the other hand, if there are many buyers and fewer sellers, or the other way around, then it is hard to make transactions at the preferred prices, thus resulting in low liquidity.

In simpler terms, liquidity can be defined as the ability of the asset in question to be sold in the marketplace with ease and at an appropriate price. Cash is the most liquid asset among all the assets because it is easily disposable for purchasing other goods. On the other hand, assets such as property, paintings, other works of art, buildings, cars, and other gadgets are relatively illiquid because it takes some time to find a buyer. Financial assets like stocks, bonds, and mutual funds are somewhere between these extremes in terms of liquidity.

Types of Liquidity

Liquidity can be broadly categorized into two main types:

1. Market Liquidity: Market liquidity refers to the extent and ease to which various assets can be traded within a given market, such as the stock market or the property market, at a known price. These are markets where the bid-offer spread is narrow, enabling smooth transactions between the buyer and the seller.
2. Accounting Liquidity: This type of liquidity is used to determine an individual or a company’s capacity to fulfill their short-term financial commitments with the help of their liquid assets. It points out how effectively they will be in a position to deal with any settlement expenses as they occur. High accounting liquidity refers to the ability of a company or an individual to meet their current obligations most efficiently without resorting to the sale of non-liquid goods.

What is Stock Market Liquidity?

Stock market liquidity can be defined as the ease at which stocks are bought or sold in the stock market while triggering minimal fluctuations in the stock price. Highly liquid markets have many participants actively trading in the markets, so it is easy for investors to take new positions or close existing ones. For instance, the stock market liquidity of blue chip stocks is usually high, and this means that it is easy to buy or sell these stocks without much fluctuations in the prices. However, illiquid markets have a few market players, and thus, when engaging in trading activities, it can affect the price of the stock.

How Does Liquidity Affect Stocks?

When you trade, you are essentially engaged with market makers – companies that offer bid and ask prices at which they are willing to complete a transaction for the stock. Market makers make their profit from buying stocks at a price, which is cheaper than the price at which they sell them also referred to as bid-ask spread.

Generally, in highly liquid stocks, the spread is usually narrow because market makers are in a position to buy and sell shares with ease. In liquid markets, a high trading volume means that market makers cannot be burdened by excess inventory. On the other hand, in low-liquidity stocks, a market maker is exposed to more risk and may not easily be able to find counterparties to trade with. Therefore, they expand the bid-ask spread to cover this risk, making the cost of trading higher for investors.

Why Liquidity Matters?

It is essential to understand stock market liquidity since it influences the conditions and costs of trading. Here are key reasons why liquidity matters:

1. Ease of Trading: This is understood as the fact that there are many buyers and sellers in the market at any given moment. This allows for efficient implementation of trades with utmost speed, which is important for traders who seek to open or close positions rapidly.
2. Price Stability: Compared to the other markets, the price variations are likely to be smaller in liquid markets due to the numerous customers and sellers. This stability is desirable for users who do not want to lose a large amount of money if the market shifts its direction.
3. Lower Trading Costs: As already explained, high liquidity leads to a scenario in which the bid-ask spread tends to narrow. This makes the expense of trading to be minimized thus enabling investors to purchase and sell assets at cheap prices.
4. Mitigation of Liquidity Risk: Liquidity risk refers to the inability of an investor to exit a particular investment within a given period without incurring a loss. This risk is reduced in high market liquidity since there will always be people to buy the assets, thus enabling the investor to sell at the market price.

How to Measure Stock Liquidity

Several metrics can help investors assess the liquidity of a stock:

1. Share Turnover: Turnover or share turnover is a financial ratio that determines the volume of shares traded divided by the number of shares. A higher figure share turnover ratio means that the liquidity of the stock is high, meaning that it is easy to trade in the market.
2. Bid-Ask Spread: This is the comparison of the price that a buyer is willing to pay and the price that a seller is willing to offer. If the bid-ask spread is narrow, then it shows the high liquidity of the stocks and if the bid-ask spread is wider then it shows the low liquidity of the stocks.
3. Trading Volume: Trading volume refers to the number of shares that are bought and sold in the market within a certain period. High trading volume usually correlates to high liquidity, so it means that large trades can be conducted on the stock without affecting the stock’s price.

Conclusion

Liquidity is one of the most important phenomena that any trader should look forward to while operating in the financial markets. High liquidity enables investors to trade with ease and at specific price levels implying the least trade expenses and the possibility of having to sell off resources. Knowledge of what liquidity is and how it can be quantified provides better control and effective insights to the investors.