What is Market Liquidity?

Market liquidity refers to the ease at which assets can exchange hands without obstructing or affecting the asset's price. If investors can easily buy and sell assets from each other without shocking the price, that particular market is highly liquid. On the other hand, if buyers and sellers have difficulty matching up, transaction volume craters and the market becomes illiquid. Trading volume and trading liquidity are often interchangeable terms in capital markets.

Think of liquidity as the oil that lubricates the engine of the market. If you don't put oil in your vehicle's engine, the gears will grind together and seize up causing the motor to sputter out. The same is true with the stock market: Without ample liquidity, prices become unstable, and investors can't move in and out easily. 

Every market needs some level of liquidity to function. One of the reasons the stock market is so efficient is that it has enough liquidity to match buyers and sellers in a continuous auction market without creating volatile prices.

Why would an investor want to hold liquid assets? For starters, they can be bought and sold quickly and don't carry high spreads or transaction costs. Additionally, liquidity means that large numbers of transactions can occur without causing excessive fluctuations in the price of the underlying assets.

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Suppose your grandparents bequeath you a collection of rare stamps valued at $20,000. These aren't the rarest stamps in the world, but they have enough scarcity to create a functional market. 

Here's your dilemma: how do you sell this rare stamp collection for its fair value? You can't load up your rare stamps broker and sell a few shares on an exchange. A $20,000 value has little meaning for a seller if you cannot find willing buyers. A rare stamp collection must be appraised, maintained and sold at a specific venue to a limited number of potential buyers. 

Sure, it only takes one buyer to complete a sale, but a smaller number of buyers always decreases the odds of a successful transaction. If you want the stamp collection sold quickly, you'll likely need to lower the price below fair value. Can you see now why investors prefer liquid markets to illiquid ones? It's much easier to sell shares of a big, exciting tech stock than a collection of obscure stamps.

Trading volume creates liquidity, but supply and demand also play a role in greasing the market's gears. Buyers and sellers must be balanced for a market to maintain its liquidity. If many investors are all looking to sell the same small-cap stock, these transactions won't be completed without causing significant downward pressure on the share price. 

To create a liquid market, ample participants must be present, and those participants must be on both the buy and sell sides of the ledger. Market depth is known as the ability to buy and sell assets in large quantities without severely changing the price. In an ideal world, investors will be trading in liquid and deep markets.

The most liquid asset is cash, which you can instantly exchange for goods and services at any business in the country. Financial advisors usually recommend having liquid funds for emergencies, like a savings account that earns minimal interest, but you can tap it immediately if a large expense pops up. Less liquid assets would include real estate, which earns a higher return (usually) but comes with a costly and time-consuming transaction process. 

The biggest and most active markets have the most liquidity— and that's the forex market. A global collective of investors trades currencies 24 hours a day during the five-day trading week. Forex trading volumes are around 25x higher than those of global equity markets. Over $5 trillion is traded daily on forex exchanges.

Large markets like commodities futures (especially oil and precious metals), large-cap U.S. stocks and bonds are also highly liquid since investors can buy and sell quickly at stable prices with tiny spreads.

Market liquidity refers to the ease and efficiency with which investors can buy and sell assets. Liquid markets also enable large transactions without significantly influencing the asset's price. The most liquid markets, such as blue-chip U.S. stocks, tend to be the largest.

Consider the daily trading volume of a large-cap ETF like the SDPR S&P 500 ETF Trust NYSE: SPY as an example of market liquidity. With an average daily share volume of over 85 million, SPY is one of the most liquid securities available on U.S. stock exchanges.

As a concept, market liquidity is inherently good. Liquid markets mean orderly transactions, low costs, and calm investors. When markets become illiquid, spreads rise, volatility increases and investors tend to abandon rationality.   

Here's a different question: do traders prefer high or low-liquidity markets? Most traders want liquid markets, but some day traders often utilize illiquid markets to make big gains in short time frames. Liquidity can be a negative attribute when searching for stocks with the potential to make big swings. But if you want stable and orderly markets, stick with highly liquid securities.