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Market Liquidity – How Does it Affect Your Trading?

Market Liquidity
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14 minute read
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Liquidity is among the most important concepts in the financial and investment world. It is essential for the well-being of exchanges, trading venues, institutional investors, retail traders. Basically, everyone with access to financial markets. In this guide, we will dive into the concept of market liquidity. We will find out how it works and why it is so important. We will cover its risks and benefits and go through some of the most liquid assets. Finally, we will see how market liquidity and volatility are related and what it means in the context of trading.

What is Market Liquidity and Market Illiquidity?

Market liquidity indicates the ease of converting assets into cash without affecting their price. Why cash? Because cash is the most liquid asset. It allows you to exchange it for basically everything.

Think of liquidity as a trade-off between the asset’s price and how quickly you can buy or sell it. The quicker you can trade the asset without affecting its price, the more liquid it is.

Liquid assets guarantee that there will always be a market participant who will get on the other side of your trade. In general, the more liquid the asset, the more stable its price.

Most traders consider liquidity a reflection of the market’s health. Investors always prefer liquid markets since they equate more stability and less risk for their long-term strategies.

“Liquidity for markets is what oil is for a car’s engine.”
– Paul Krugman

On the other hand, the lack of liquidity is a state of the market/asset where you struggle to convert the security into cash. This means there are not enough buyers, or at least not enough buyers to agree to your preferred terms.

This what we call illiquidity. Illiquid assets may prevent you from capitalizing on a particular trading opportunity by being unable to buy/sell at your preferred time and price.

Traders who get stuck in open trades while failing to find buyers become more willing to accept lower prices. That is why we say that liquidity or the lack of it can influence the instrument’s price.

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Understanding How Market Liquidity Works

Market liquidity depends on the number of buyers, sellers, and the transactions between them. The more buyers and sellers on the market, the more stable and transparent the prices are.

Market liquidity depends on how much interest the public has in the particular asset in question. For example, Apple’s stock (AAPL) is much more liquid than the average tech company’s shares. The reason is that the business is well-known, with solid fundamentals, so investors often have a greater interest in it.

According to theory, in a liquid market, the buying price (bid price) should be close to the selling price (ask price). Usually, the difference between them less than 1% of the price, sometimes even just a few pennies. This indicates that buyers’ and sellers’ views perceptions about the traded instrument are similar. This indicates a transparent and stable market.

On the other hand, when the spread between the bid and the ask price widens, the market gets less liquid. The difference in the spread may be up to a few percentages of the trading price in less traded assets. Illiquid markets make it harder for investors to buy and sell at their preferred price.

What Determines Market Liquidity?

How liquid an asset depends on several things. One is the asset class. For example, equities are much more liquid than real estate.

The liquidity of other assets, like derivatives and commodities, often depends on their size and how many open exchanges they are traded on.

Generally speaking, instruments traded on big exchanges enjoy the highest liquidity. On the other hand, instruments traded on dark or less-developed markets tend to be more illiquid. The NYSE is many times more liquid than the Stockholm Stock Exchange, for example.

Market liquidity also depends on the time of the day you trade. Trading after hours almost always means fewer buyers and sellers on the market. Besides, trading foreign instruments like the Euro during Asian trading hours will also result in lower liquidity. If you wait and trade the instrument during the official hours of European exchanges, you will surely get a better bid-ask spread.

To see what market liquidity looks like in numbers, let’s look at an example.

On October 9th, 2020, Google’s trading volume was 1.3M. This sounds like a lot, but if we put it in perspective, the trading volume for Tesla’s shares on the same day was 42M. Both stocks are considered highly liquid, and you can trade them without worrying about getting stuck into a trade.

However, make sure to avoid trading shares with a daily volume in the tens or hundreds. This is another type of market that traders usually consider illiquid.

How Are Market Liquidity and Volatility Related?

High market liquidity usually leads to low market volatility. On the other hand, low liquidity can destabilize prices.

Markets with sufficient trading volume are known to have stable prices and a good environment for institutional traders.

Assets that lack enough investment interest are grounds for speculation. This means their prices are unstable, which is why they are considered riskier and unhealthier markets.

Some examples of highly liquid and low volatility assets are bonds and blue-chip stocks.

To better understand the relationship between market liquidity and volatility, think of orders as a way for companies or individuals to vote on where the market is going next. As we know, the more votes collected, the more representative and trustworthy the final result is.

Liquidity and Volatility in Trading

Now let’s translate that concept into the context of trading. In this case, the bigger the number of buy/sell orders (high liquidity), the more stable the price will get (low volatility).

This means that volatility and liquidity have an inverse relationship. If volatility increases, that indicates lower liquidity in most cases. On the other hand, if liquidity spikes, then volatility will most likely decrease.

Here we should also mention the relationship between liquidity and price. An asset is truly liquid when buying/selling doesn’t significantly affect its price. Even in large quantities at once.

Imagine a situation where you live in a small neighborhood and manage to sell your house for a significantly higher price than the average on the market. Then your neighbor does the same. Due to the small number of real estate available in the region (i.e., the market is illiquid), the chance is these two events will drive the average house price higher.

It is the same case with stocks. If an investor holds a significant portion of a company’s shares with low trading volume and dumps them at once, he will drive the share price down. These investors are called “whales” because they can cause price “splashes” in illiquid markets.

Why is Market Liquidity Important?

Most market participants’ primary goal usually is capital preservation, so liquidity often is the make-or-break point that defines whether to enter a particular market. If investors want to ensure more stable and less risky performance, they look for markets with high liquidity.

Historically speaking, market liquidity has often served as a warning sign of looming problems with the economy. One of the reasons is that the lack of liquidity may often contribute to market bubbles forming.

Liquidity in the Context of the Housing Bubble

Let’s take the housing bubble, for example. During the last two decades, we have witnessed several housing bubbles across the world. One of them led to the most devastating financial crisis since the Great Depression.

A housing bubble forms when the number of sellers on the market surpasses buyers’ number by a large margin. This leads to the market becoming illiquid, without it being reflected in the price (i.e., the price moves disproportionally).

When there is an equilibrium between buyers and sellers, the demand is stable, which leads to more houses being built. This, on the other hand, leads to higher real estate prices. At some point, buyers start investing in real estate not just to live in but to profit from it. This further increases the demand.

However, this process is finite. Once it reaches the critical point where the supply significantly surpasses the demand, the market becomes illiquid. After that, the prices get volatile. The real estate loses value, and, at some point, the bubble bursts.

Of course, several other factors also contribute to housing bubbles. Like cheap credit, for example, you get the idea.

This is the case with markets as well. Stable and liquid markets are a sign of a good and healthy environment. They allow institutional investors like pension funds and insurance companies to take part and invest their capital. These companies are required to adhere to stringent regulatory requirements.

What is a Liquid Asset?

A liquid asset is a high-quality asset that allows you to quickly convert it into cash without affecting its price.

Think of liquid assets as the most popular assets. If you try to think of examples, you will probably come up with shares of companies like Apple, Tesla, Netflix, futures on commodities like oil, gold, or corn, US treasury bonds, currencies like the USD and the Euro, and so on.

And you will be right. The instruments above are examples of some of the most liquid assets.

However, the general consensus is that an asset is liquid when bought or sold within a few hours. Alternatively, when it has a trading volume of at least tens of thousands of contracts/shares per day.

It is worth noting that an asset that is highly liquid today may not be enjoying such an interest a year or a decade later. Markets are changing rapidly, and, under the influence of different factors in the economy and the social life, trends shift. This means the market leaders today may not be the ones of tomorrow.

Drastic Market Changes in 2020

Let’s think of the COVID pandemic, for example. It accelerated the interest in Netflix, which was already a highly liquid stock, even higher. It’s the same with the shares of the companies competing to develop a vaccine.

On the other hand, it cooled the interest in the shares of airline or tourism-related companies.

This shows that there isn’t a universal rule to classify particular assets as liquid. Although the theory suggests that stocks, bonds, and futures are liquid, it is often advisable to look at the fundamentals of the specific asset, its characteristics, time of year, external factors, etc.

That is why it is better to stick to the idea that a liquid asset attracts interest and can quickly be bought or sold with no implications on its price.

What Are The Most Liquid Markets?

Understandably, the most liquid asset is cash.

The most liquid assets are usually Forex, equities (blue-chip stocks in particular), and bonds in terms of investments. ETFs, futures, and mutual funds also enjoy high liquidity.

However, as we mentioned already, liquidity nowadays is less dependent on the asset class than on a particular instrument.

For example, we have stocks like Microsoft with millions in trading volume per day. Meanwhile, there are penny stocks that are traded just a few times per day.

We have ETFs like the SPY with trading volume exceeding 70M per day, while, on the other hand, we also have inverted niche-specific and sector ETFs traded a couple of hundred times per day.

There are futures on oil, natural gas, and corn on the liquid spectrum of the market. Meanwhile, contracts like the Micro Indian Rupee (MIR) aren’t traded as much.

We also have currencies like the USD, GBP, the Euro, and the Yen that are highly liquid, and others like the Iranian Rial, the Guinean Franc, or the Ugandan Shilling that don’t see much trading either.

In a nutshell, the more popular the instrument, the more liquid it is.

Liquidity Risks and Benefits

As one of the most important finance concepts, market liquidity has some substantial risks and benefits that we should talk about.  

Being familiar with them allows traders to maximize their understanding of market liquidity and better navigate the periods with low and high trading volume.

Risks of Liquidity

Periods of low market liquidity are where most of the risk lies. Low liquidity leads to unstable prices and worse market conditions.

When there is not enough trading volume, the market becomes more fragile. In these scenarios, the price is prone to manipulation, and the bigger market orders have a heavy influence on it.

That is why investors with significant exposure to a particular low liquidity asset class are considered a potential high systemic risk source. If the instrument’s price starts going south and the investor decides to dump his assets, it leads to a snowball effect, and the price tumbles even further. In the end, smaller investors lose the most.

Low liquidity should serve as a warning sign that, if you decide to invest in that particular market, there is a risk of getting stuck during unstable periods as you might fail to execute your orders. This basically means you will be less flexible in minimizing potential losses or capturing profit momentum opportunities.

It is worth noting that most traders associate periods right after dramatic political, global, or market events with low liquidity—this includes the post 9/11 period, the months after the Global Financial Crisis, etc. As fear and uncertainty take over, more investors head for the exit, and the liquidity drains further. The prices then become much more unstable.

This is worth keeping an eye on when investing in assets with low trading volume.

To navigate the risk of low liquidity, make sure to always pay attention to trading volume, the relevant news for the asset, and the bid-ask spread (low liquidity markets are known for having wider spreads).

Benefits of Liquidity

Liquidity is the fuel that powers financial markets. The good thing is that usually, when the economy is doing well, the global situation is stable, and there is relative equilibrium between buyers and sellers. Liquidity is often sufficient even in niche-specific assets.

As an investor, you should realize that markets can still be a healthy environment, even during periods of low liquidity or dramatic events.

Think of the COVID pandemic, for example. It is natural to assume that the tourism sector would get hit the hardest. The travel restrictions make that a foregone conclusion, and this is mostly correct. However, this isn’t a universal truth. If we look at Booking.com, a business that should be stagnating in times like these, we would see that the company did a pretty good job and even managed to further expand its business.

This shows that no matter whether it is low or high, liquidity is essential for markets and can always create opportunities for investors.

“My experience is that when people want to give something away at a ridiculous price because they have to, not because they want to, that’s a good time to buy.”
Seth Klarman

We can go as far as saying that liquidity is the most important characteristic of financial markets. It is directly responsible for price stability, buyers’ and sellers’ presence, behavior, and more.

FAQs

How Does Liquidity Affect Different Assets and Their Value?

Higher liquidity leads to more stable asset prices. It can also contribute to ensuring a steadily growing value of the asset class. On the other hand, low liquidity can lead to increased volatility and indirectly decrease its price.
For example, if the liquidity for the assets in your portfolio drains, you will have to sell them at a lower price to minimize losses or keep them and hope their price soon starts representing their real value.
Liquidity may or may not directly affect the asset’s value in the short term but will indeed affect its price. If the liquidity retains its levels for the long-term, it might start affecting the asset’s value.

How Does Market Liquidity Affect Your Trading?

Speculators and more aggressive traders usually seek assets with higher volatility, which often are illiquid markets. Day traders favor liquid markets as they want to get in and out of a trade quickly and without keeping open positions overnight.
Large-scale traders and high-frequency trading firms prefer highly liquid markets, although the latter thrive on volatility as well. Institutional and small investors, alongside retail traders, also favor liquid markets with stable prices.
All-in-all, liquidity is a determining factor for market participants on whether to invest in a particular asset class.

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