4min read
Published on: Apr 23, 2024
#Trading 101
Market liquidity impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as someone is always willing to take the other side of a given position.
KEY TAKEAWAYS
• A highly liquid asset can be sold in exchange for cash very easily and efficiently.
• An illiquid asset takes a lot of time to get sold, which often happens at a loss.
• Cash is considered the most liquid asset as it can be exchanged for other assets quickly and efficiently.
Anyone actively trading or even mildly aware of the stock market must have heard of “liquidity.” Even though they use it frequently, most people hardly understand the term. It is a fairly simple concept but highly misunderstood or less understood. This article will explain what is liquidity in trading and why it matters in simple terms.
Let us take an example to understand the concept of liquidity. Suppose there is a man who lives in Delhi, the capital of India. He lives in a house that he owns. The man comes from a small village in central India and owns a house. Now that the family is expanding, he wants to buy another house. For this purpose, he decides to sell the ancestral house in his village.
But the man cannot find any buyer in the hinterland. Meanwhile, he often receives unsolicited offers to purchase his Delhi house. In the above case, the Delhi house is highly liquid, but the old village house in the town isn’t. An asset is considered liquid when it can be bought and sold quickly and easily without much price difference.
Image: Liquid and illiquid explained
Since the Delhi house can be sold quickly at a lucrative price, it is highly liquid. On the other hand, a house in a small village is illiquid because it can only be sold at a low price and it will take a lot of time to find a buyer. A highly liquid asset can be sold in exchange for cash very easily and efficiently. In contrast, selling an illiquid asset takes a lot of time, and often at a loss.
Cash is considered to be the most liquid asset as it can be exchanged for other assets quickly and efficiently. When we talk about liquidity, we primarily refer to two types: market liquidity and accounting liquidity.
(i) Market Liquidity: Market liquidity refers to the ease and efficiency of trading stocks in the markets.
(ii) Accounting Liquidity. A stock on the charts is highly liquid if it has a small bid-ask spread. A spread is the difference between a stock’s asking price and sale price. Accounting liquidity refers to the ease and efficiency with which a company can pay off its debts with the available liquid assets.
Recommended read: Back to the Basics: The Law of Supply and Demand in Finance
It is very difficult to trade assets in an illiquid market. In the example cited above, the house in a small village in central India is an illiquid or less liquid asset. There are simply no or very few buyers in an illiquid market, making it very difficult to sell assets at a reasonable price. Consequently, the bid (selling) price is very low compared to the asking price. An illiquid market has a very broad spread, therefore.
Trading a liquid asset is quite easy in comparison. Suppose you own a ticket to a Taylor Swift concert, but an urgent matter arises. You decide to auction the ticket on a social media site, and voila, your ticket gets sold without any loss (or maybe even gaining you a few extra dollars) within a few hours. If Swift keeps dropping bangers and bangers, Swifties will keep lining up for a concert. In short, a Taylor Swift concert will most likely be highly liquid likelihood. Traders need to learn about the market liquidity and accounting liquidity of the stock they invest in.
An asset’s ask demands liquidity. Conversely, its bid supplies liquidity. An asset’s bid-ask spread rises if fewer buyers are in the market. Conversely, the spread falls if there are a lot of buyers in the market. In short, an asset’s liquidity is inversely proportional to its bid-ask spread.
An asset with a narrow bid-ask spread is demanded the most and is highly liquid. An asset with a broad spread is demanded the least and is less liquid. A market for stocks, derivatives, futures, bonds, etc., is highly liquid. On the other hand, markets for debt instruments and OTC stocks are very illiquid.
Market liquidity is important for several reasons, mainly because it impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as someone is always willing to take the other side of a given position. This can attract speculators and investors to the market, which adds to the favourable market conditions.
In a liquid market, a seller will quickly find a buyer without cutting the asset's price to make it attractive. Conversely, buyers won’t have to pay more to secure their desired asset.
An asset’s liquidity is also a key factor in determining the spread a leveraged trading provider can offer. High liquidity means many orders to buy and sell in the underlying market, increasing the probability that the highest price any buyer is prepared to pay and the lowest price any seller is happy to accept will move closer together. In other words, the bid-offer spread will tighten.
As we derive our prices from those in the underlying market, a lower bid-offer spread here will translate into lower spreads offered on the platform. If a market is illiquid, it could mean a much wider spread.
When trading financial markets, liquidity needs to be considered before every position is opened or closed. A lack of liquidity is often associated with increased risk.
If the market is volatile but there are fewer buyers than sellers, closing your position can be more difficult. You could risk becoming stuck in a losing position or have to go to multiple parties with different prices just to fill your order.
One way to manage liquidity risk is through guaranteed stops, a type of stop-loss that ensures your position is closed at your pre-selected price level. Guaranteed stops are not impacted by volatility, so they can be useful for navigating tumultuous markets. If your guaranteed stop is triggered, though, there would be a small fee to pay.
The most important thing to remember is that market liquidity is not necessarily fixed. It works on a dynamic scale of high liquidity to low liquidity. A market’s position on the spectrum depends on various factors, such as the volume of traders and the time of day.
If you are trading an overseas market or a market out of hours, you might find fewer market participants, so the liquidity is much lower. For example, there might be less liquidity on GBP forex pairs during Asian trading hours. This could lead to wider spreads than during the European trading hours.
What are the most liquid markets?
• Forex (major pairs)
• Large-cap stocks
• Commodities
Although these are three of the most liquid financial markets, cash is the most liquid asset because it can be used to buy nearly anything. Therefore, the liquidity of most other assets is judged by the speed and ease at which they can be converted into cash.
Forex is considered the most liquid market in the world due to its high volume and frequency of trading.
Governments, all major banks, insurance companies, investment houses, traders, and even individuals going on holiday contribute to the vast amount of trade on the forex market daily. It is estimated that more than $5 trillion is traded on the forex market daily.
Despite experiencing high levels of liquidity, the forex market does not exhibit stable pricing. The large number of people trading major pairs leads to differing opinions about the price, which leads to daily price movements. This is especially true when the market digests news. Although it creates high levels of volatility, the prices are usually kept within a range and traded in smaller increments.
It is generally assumed that the major forex pairs – the most popularly traded pairs – are the most liquid. This means that pairs like EUR/USD, GBP/USD or USD/JPY experience high liquidity.
In forex, liquidity matters because it tends to reduce the risk of slippage allows for faster order execution, and tightens bid-offer spreads.
For a stock to be considered liquid, its shares must be able to be bought and sold quickly and with minimal impact on the stock’s price. According to Canadian regulators, a liquid stock is classified as one that is traded at least 100 times per day and has an average daily trading volume of at least $1 million.
The shares of companies traded on major stock exchanges tend to be highly liquid, and these are known as large-capitalisation or large-cap stocks.
To qualify as a large-cap stock, a company typically needs a $10 billion or more capitalisation. They are also normally blue-chip stocks, which have established earnings and revenue. Conventional theory suggests that companies with larger market caps are more likely to have stable prices and a higher volume of traders, which means that the shares can be converted to cash relatively quickly.
A market's accessibility is linked to its liquidity. Traditionally, commodity markets were considered significantly less liquid than other markets because the physical delivery of assets made them challenging to speculate on. But thanks to the rise of derivative products—including CFDs, futures, ETFs, and ETNS—it is easier to trade commodities than ever before.
There are different degrees of liquidity depending on which commodity you are looking to trade. The most frequently traded commodities are generally the most liquid, such as:
• Crude oil: Perhaps the most highly traded commodity in the world is crude oil due to its vast number of applications and the number of ways that you can trade it.
• Precious metals: Gold is the most liquid precious metal, as it experiences the highest trading volume. There are a vast number of different products available for trading in the market.
• Sugar: Sugar is the most popular ingredient in our diets and has become one of the most widely traded markets. At one point, it was even known as ‘white gold.’
We recommend that BitDelta traders learn about the market liquidity and accounting liquidity of a stock they are interested in trading. While the former informs them about the stock's current market dynamics, the latter allows them to assess the company's financial health. BitDelta traders need to understand the liquidity of their trading portfolio to be well aware of any potential risks involved.
A well-read and informed trader makes wise investment decisions despite any market hiccups. Keep following the BitDelta Academy to learn more about the basics of the financial markets in a detailed yet fun manner. We offer more than 400 trading pairs to our customers who are located across different countries. Register on BitDelta to start your trading journey today.
The degree of liquidity is best known by the amount you can buy or sell an asset without changing its price.
Liquidity is high when you can easily purchase and/or sell an asset at a reasonable and predictable price.
Yes, liquidity is good because it enables trades to be done with great ease and speed and little to no effect on the prices of the assets.
Trade on popular markets or assets with high trading frequencies is advised to prevent low liquidity.
A liquidity sweep is recognised when big orders act to quickly reorder the bid-ask spread to wipe out smaller orders.
High liquidity is equally crucial, but it typically implies that the prices are more stable, which can be beneficial when doing trades.
Look at the trading volume and the bid-ask spreads; high and narrow spreads are desirable.
Use limit orders to determine the price you are willing to pay or the price you want to get, and trade in small quantities to avoid moving the price.
True. Economic news or events can influence liquidity.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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