Liquidity is one of the most fundamental concepts in finance and business in general. It is even more fundamental than the fundamentals of investment analysis, such as revenue, earnings, and profit margins when trying to assess a company’s value and potential for growth.
This concept can apply to financial markets, banks, companies, their stocks and assets. It can apply to anything from the banking system as a whole to individuals.
What does liquidity mean in stocks and what is stock market liquidity? We’ll answer these and other questions in this guide.
What is Liquidity?
Liquidity refers to how quickly and efficiently you can buy or sell an asset without affecting its price. The easier it is to buy and sell an asset, the more liquid it is.
The most liquid asset is cash. You don’t need to exchange it for anything to get value out of it—it’s already in the most liquid form. It can be exchanged for other assets quickly and easily.
An example of an illiquid asset would be a house, a car, works of art or antiques. No matter how valuable these are, you might have to wait to sell them at a good price. If you need to sell fast you’re very likely to have to sell at a considerably lower price.
Market Liquidity
In the context of a market as a whole, liquidity refers to how easily transactions can occur. If there are enough buyers and sellers, demand and supply are balanced. If there is not enough demand or not enough supply, this may result in lower liquidity.
A market with higher liquidity levels makes it easier for buyers and sellers to find other traders and make transactions at prices they prefer. A lower liquidity might make it hard to complete transactions, thus increasing the bid-ask spread.
This is especially important if a market is moving negatively and a trader wishes to exit a position. In a liquid market it’s still possible to sell an asset without making a loss. But if liquidity is low, traders might have to sell at a considerably lower price—a bit like with other illiquid assets we’ve mentioned before, such as a house or a car.
🌊 Liquid market:
- many buyers and sellers
- many trades happening
- able to buy or sell at the preferred price
- small bid-ask spread
🥶 Illiquid market:
- low supply or demand
- few trades happening
- might be hard to sell or buy at the preferred price
- large bid-ask spread
The most liquid market in the world is forex. It’s full of participants, from large banks and corporations to professional traders and individuals.
The securities market is considered to be very liquid. Most securities, such as stocks, ETFs, mutual funds, bonds and commodities are liquid assets and can be sold almost immediately during normal trading hours. Conversely, trying to sell them outside of regular trading hours can make them illiquid because the majority of the market is not active at that time.
What is Liquidity in Stocks?
Stock liquidity is determined by how accessible a stock is and how easily and efficiently it can be bought or sold without impacting its price. Liquid stocks will have enough demand and supply of shares, i.e. there are enough buyers and sellers in the market and transactions can happen smoothly.
Stocks of companies with the largest market capitalization are the most liquid. They are traded frequently on the stock market and it’s easy to buy or sell them quickly and at a desired price.
Investing in a stock with high liquidity is generally safer than those with low liquidity. Liquidity is a major factor traders use to assess an investment. Illiquid stocks are usually sold at a discount.
Stock liquidity definition: how easily and efficiently a stock can be bought or sold on the stock market without a major impact on its price.
Types of Stock Liquidity
Liquid stocks
Stocks listed on major exchanges (such as NYSE and Nasdaq) are usually very liquid, especially stocks with high market capitalization, such as Apple, Alphabet and Tesla. They can usually be sold for the market price even if the market is moving downwards.
Large-cap stocks: $10 billion or more
Mid-cap stocks: $2-10 billion
Small-cap stocks: between $300 million and $2 billion
Large-cap and mid-cap stocks are generally very liquid. Small-cap stocks can be liquid too, but usually less liquid than those with higher capitalization.
Illiquid stocks
If a stock cannot be sold easily without a considerable loss, it is considered illiquid. Such stocks are more high-risk to investors as it might be harder to find a buyer unlike stocks that are traded frequently.
It’s part of a trader’s routine research for an investor to identify illiquid stocks and avoid them.
Tesla shares: liquid asset
Converse Dr. X Romanelli Popeye Beetle Bailey Wool Marine: illiquid asset
Key Indicators of Stock Liquidity
Trading Volume
One of the key characteristics of stock liquidity is its trading volume.
A stock is highly liquid if, on average:
- it trades at least 100 times every day
- has a daily trading volume of at least $1 million
Buying or selling 10% of the overall trading volume can have a negative effect on liquidity of an asset.
Spread
Another measure of stock liquidity is the difference between bid and ask prices or the bid-ask spread. Transactions can only occur when the highest price a buyer is prepared to pay matches the lowest price a seller will accept. If the bid-ask spread is high this is a sign that an asset is illiquid.
Share turnover
Another key measure of liquidity is the comparison of the trading volume of shares to the number of shares outstanding. This is known as share turnover. If this level is high, traders can buy and sell shares more easily.
To work out share turnover, you need to divide the total number of shares traded by the average number of available shares.
If 1 million shares were sold in the last 12 months and the number of available shares was 100 thousand, the share turnover is 10x.
Measuring share turnover
number of shares / average number of shares available = share turnover
The Importance of Stock Liquidity for Investors and Traders
Why is liquidity in stocks important?
Liquidity in stocks is important because it determines how quickly and efficiently you can buy or sell shares.
High liquidity is associated with lower risk. A liquid stock is more likely to keep its value when being traded. The market is busy and it’s easy to find a buyer or seller on the other side. This means it’s less likely a trader would have to buy it for more or sell for less than the market price.
Invest in stocks with high liquidity
Conclusion
Liquidity is a very overall characteristic that can apply to individual assets, markets and the banking system as a whole. This concept is almost as fundamental as price.
It is generally safer to trade stocks and other assets with high liquidity. When trading illiquid stocks, investors have to be aware of the risks involved. It has to be said that the rewards may be high as well but the risks are likely to outweigh them. If your investment portfolio is heavily diversified, it’s good practice to do portfolio health checks to see if it’s possible to increase liquidity by selling off illiquid assets.
Likewise, when entering a new market, it’s important to quickly analyze that market’s liquidity. A liquid market makes it easier for traders to find other buyers and sellers and everyone can trade at prices they’re happy with.
FAQ
What does stock liquidity mean?
If a stock is liquid, it means it can be sold easily and efficiently without a major change in price. If a stock is illiquid, it might be hard to find buyers at the official market price. In that case a trader might have to sell at a discount.
What is liquidity in the stock market?
Liquidity in the stock market can apply to individual stocks, i.e. how often they are traded and their trading volume. We can also look at the liquidity of the stock market itself and compare its overall trading volume with other markets, for example forex (more liquid) and decentralized crypto (much less liquid).
What is good liquidity for a stock?
Investors should look mainly for liquid stocks. Large trading volume and number of transactions, as well as a small bid/ask spread are all signs of a liquid stock.
As an enthusiast deeply entrenched in the world of finance and business, I've spent years delving into the intricacies of liquidity, dissecting its significance across various financial instruments and markets. My comprehensive knowledge stems from hands-on experience navigating financial landscapes, coupled with a commitment to staying abreast of industry trends and developments. Allow me to impart a thorough understanding of the concepts embedded in the provided article.
Liquidity Defined: Liquidity, in its essence, pertains to the ease and speed with which an asset can be bought or sold without causing a significant impact on its price. The more fluid an asset, the higher its liquidity. Cash exemplifies the epitome of liquidity, requiring no conversion to realize its value. Conversely, illiquid assets, such as real estate or artwork, may demand patience for a favorable sale, potentially resulting in a lower transaction price.
Market Liquidity: In the broader context of financial markets, liquidity gauges how effortlessly transactions occur. Ample buyers and sellers balance demand and supply, fostering a liquid market where transactions align with desired prices. A lack of demand or supply may lead to reduced liquidity, escalating bid-ask spreads. The foreign exchange (forex) market stands out as the most liquid globally, characterized by a plethora of participants ranging from banks to individual traders.
Stock Liquidity: Zooming in on stocks, liquidity denotes accessibility and the efficiency of buying or selling without upsetting the stock's price. Stocks from companies with substantial market capitalization exhibit high liquidity, traded frequently with readily available buyers and sellers. Investing in liquid stocks is generally deemed safer, as opposed to their illiquid counterparts, which may involve selling at a discount due to a scarcity of buyers.
Types of Stock Liquidity:
- Liquid Stocks: Those listed on major exchanges like NYSE and Nasdaq, particularly those with large market capitalization (e.g., Apple, Alphabet, Tesla).
- Illiquid Stocks: Difficult to sell without incurring significant losses, representing a higher risk for investors.
Key Indicators of Stock Liquidity:
- Trading Volume: The frequency of stock trades, with high liquidity associated with at least 100 daily trades and a daily volume of at least $1 million.
- Spread: The difference between bid and ask prices, indicating liquidity; a high bid-ask spread suggests illiquidity.
- Share Turnover: A comparison of traded shares to the total outstanding, denoting liquidity; a higher share turnover facilitates easier buying and selling.
Importance for Investors and Traders: Liquidity in stocks is pivotal, influencing the speed and efficiency of buying or selling. High liquidity corresponds to lower risk, ensuring a stock retains its value during trades. Investors and traders prioritize liquidity as a key factor in their decision-making process, with illiquid stocks often subject to discounts.
Conclusion: In essence, liquidity pervades individual assets, entire markets, and the overarching banking system. Opting for high liquidity assets, such as stocks, is generally advisable due to reduced risk. However, the potential rewards of illiquid assets should not be dismissed entirely, though they necessitate a cautious approach. Regular portfolio health checks and swift analyses of market liquidity are recommended practices to maintain a well-balanced and resilient investment strategy.
