What is liquidity?
In a science classroom, the answer is one of the three states of matter.
In finance, liquidity refers to the state of the market, not a state of matter. Liquidity is one of the most important factors in any market. Without it, that market would dry up and cease to exist. Liquidity enables buyers and sellers to enter transactions affordably and efficiently.
We'll walk through how to define liquidity, how it influences asset prices and investor behavior and why it's necessary for markets to function properly.
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 become 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 scenario is true in asset markets. Without ample liquidity, prices become unstable, and investors can't move in and out easily.
An Overview of Market Liquidity
Why would a person want assets with liquidity? Because liquid assets 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.
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. Let's imagine a highly illiquid market to understand better how market liquidity works.
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.
What Causes Market Liquidity?
In economics, a country's economy is formed simply by millions of people waking up every day and going to work. Market liquidity forms similarly: by millions of individual investors, institutions and speculators showing up daily to initiate their trades.
However, market liquidity takes a little more than just everyone showing up. Trading volume usually 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.
How to Measure Liquidity in the Markets
What does liquidity mean to investors? Liquid markets are preferred for buying and selling since transaction costs are low, and trades are completed instantly at the ideal price. But determining how liquid a market is requires learning a few key statistics. Here are four important numbers to watch when researching different assets.
Volatility
Large price gyrations are a common calling card of illiquid (and unstable) markets. Microcap penny stocks frequently trade with massive price volatility, while more liquid large caps tend to have less drastic price swings. A highly volatile market could mean that volume is drying up or that investors are all on the same side of the trade.
Average Daily Share Volume
Volume is an easy statistic to look up and supplies investors with useful information about the liquidity and depth of an asset's market. One way to measure liquidity in the stock market is to compare the current day's volume to the average volume over a preceding period. If the daily volume slows down, the asset market becomes less liquid as investors stay away. Increasing volume could mean upward or downward momentum is entering the market, but declining volume is almost always a bad sign for an asset.
Bid/Ask Spreads
The spread is the difference between the amount an investor receives for an asset and the price the buyer pays. Bid/ask spreads are as low as a few pennies in most liquid markets. But in illiquid markets, spreads widen as market makers have more difficulty matching up buyers and sellers. A high spread means more of your capital is eaten by transaction costs since you'll eat the difference between the bid and the ask on the trade.
Market Cap and Share Float
Larger companies are often the most liquid simply because they have many shares that investors find desirable. The "float" refers to the number of shares available for traders to purchase on exchanges. Shares in the float are the most liquid since insiders don't hold them and who usually have long-term objectives. When share floats are low, the market can quickly become illiquid since a relatively small buy or sell order can have an outsized influence on the price.
Low-float penny stocks are often the target of pump-and-dump scammers since they can create volatility with a small capital outflow.
Is Market Liquidity Good or Bad?
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.
What Are the Most Liquid 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; that's the forex market. Currencies are traded 24 hours a day during the five-day trading week by a global collective of investors. Forex trading volumes are around 25 times higher than that 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 like Treasuries are also highly liquid since investors can buy and sell quickly at stable prices with tiny spreads.
What is liquidity in stocks? Stock market liquidity can vary depending on the sector or size of the company. When researching a stock's liquidity, you'll want to look at the average daily trading volume, bid/ask spreads and the market cap. Highly liquid stocks will trade frequently with small spreads (like large caps). Not all small-cap stocks are illiquid, but company size often influences the stock's liquidity through the float, which refers to the number of shares available for trading. Penny stocks tend to have low floats and illiquidity, which creates volatile price spikes and the risk that you won't find a seller when you want to unload your shares.
For contrast, look at the annual stock charts of two different automotive companies: tiny Phoenix Motors Inc. NASDAQ: PEV with its $16 million market cap and 30,000 average daily share volume and parts retail giant O'Reilly Automotive Inc. NASDAQ: ORLY and its $57 billion market cap and 425,000 average daily share volume.
ORLY outperformed PEV during the time frame, but PEV was also more volatile, with large up-and-downswings throughout the year. Of course, this doesn't mean that you should own ORLY over PEV in every situation, but large-cap stocks with massive share volume will always be more liquid than small-caps with minimal volume and low float counts.
Highly Liquid Markets Benefit Traders, but Some Strategies Work Best in Illiquid Markets
The liquidity in markets is more of an overarching concept than a precisely-measured metric. You can measure variables like volume and spreads, but the liquidity definition is more abstract than concrete. For markets to function properly, liquidity must be present.
Without a reasonably balanced number of buyers and sellers, any asset market will freeze up quicker than the Dallas Cowboys in the playoffs. Some day or swing traders with advanced strategies may prefer to live in illiquid territory, but most market participants want fast, cheap and efficient transactions.
FAQs
What is the liquidity meaning in stocks? Here are a few commonly asked questions about market liquidity and how it influences asset prices.
What is meant by market liquidity?
Market liquidity refers to the ease and efficiency that investors can buy and sell assets. Liquid markets also enable large transactions made without significantly influencing the asset's price. The most liquid markets, such as blue-chip U.S. stocks, tend to be the largest.
What is an example of market liquidity?
Consider the daily trading volume of a large-cap ETF like the SDPR S&P 500 ETF Trust NYSE: SPY for 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.
Why is market liquidity important and why is it a good thing?
Market liquidity is a good thing for several reasons. First, liquid markets enable buyers and sellers to trade assets close to their desired prices. When volume is low and liquidity dries up, buyers and sellers must consider taking a worse price to close their transactions quickly. Additionally, the more liquid the market, the lower the bid/ask spread since market makers can more efficiently pair buyers and sellers with comparable price points.
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