What is Liquidity?
Liquidity is something that many investors fail to take into consideration or understand, which then leads to the failure of their financial plans during critical times. Lack of liquidity can cause more problems than any other aspect of finance. So, here’s a look at what liquidity is and how it affects the market.
Liquidity
Liquidity is described as the degree to which an asset or financial instrument can be speedily purchased or sold in the market, without affecting the price of the asset. Cash is considered to have the maximum liquidity, while collectibles, jewellery and real estate are not as liquid.
There are basically two types of liquidity.
1. Market Liquidity
It is the extent to which a market, such as the stock market, real estate market, etc., allows an asset or instrument to be sold, without affecting its price. Stock markets are known to have high liquidity. In an exchange with high volumes of trade, the gap between the price a buyer offers and the price that a seller demands for an asset will be narrow.
If the market is being traded regularly, there will be a high volume of buyers and sellers willing to take the other side of a given position. This will help a seller find a buyer quickly without cutting the price, while buyers won’t have to pay extra to buy the asset they want. If there are only limited buyers and sellers, trading irregularly, the market tends to have low liquidity.
2. Accounting Liquidity
This is the ability of a person or a firm to pay off debts in a given period of time. It includes assessment of liquid assets to liabilities that are due within one year. Accounting liquidity can be measured by a number of ratios, depending on the definition of liquid assets being used.
Here, we look at market liquidity, its impact and what impacts it in turn.
The Most Liquid and Illiquid Markets
Forex is considered to be the most liquid market in the world, due to its high volume and frequency of trade. This makes spreads very tight in forex pairs like the USD/JPY, GBP/USD, and other majors. Small market cap stocks will generally have a wider spread, meaning that they have low liquidity in the market.
Importance of Liquidity
Lack of liquidity can result in slower order execution. This can then lead to added cost of trading and impact a trader’s profitability from the trade. For example, you want to buy 1,000 shares of firm ABC, which is selling at a current price of $100 per share. You place the market order and it gets executed when the price reaches $101 per share. This means that a delay in execution costs you an additional $1,000 on the whole trade. Delay in execution due to lack of liquidity results in slippage.
Slippage is when you get a different price than expected on entry or exit from a trade. To help eliminate or reduce slippage, traders use limit orders, instead of market orders. A limit order only fills at the price you want, or better. Unlike a market order, it won’t fill at a lower price. By using a limit order, you avoid slippage.
Effect of Liquidity on Asset Value
Market liquidity of assets has an impact on their price and expected returns from a trade. It has been proven theoretically and empirically that investors demand higher returns on assets with less market liquidity to cover up the high cost endured by them on trading such assets. An asset with higher market liquidity will have a higher price and low return on investment. If the market liquidity risk is higher for an asset, then risk-averse investors will demand higher returns on their investment.
Impact on Large Traders
While liquidity impacts all traders, its effect is higher on larger traders. Large traders need a market that can easily absorb their orders, even when they’re using high leverage. For large traders, liquidity is a very important issue and they need to place their orders without moving the market. They also need to have a clear idea of where they will be able to exit, regardless of whether the trade ends up being successful or not.
Large traders (like big funds and central banks) cannot simply buy or sell large positions whenever and wherever they wish to. Instead, they have to look for places where liquidity is aggregating and stops are helping them in an indirect way.
Factors Affecting Liquidity
- There are good reasons to worry about liquidity before investing. Use of technical analysis can help manage the risks associated with liquidity, without affecting your financial stability.
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