What Is liquidity
Liquidity captures the extent to which a financial instrument can be bought and sold quickly at a stable price. There is no one superior measure of liquidity, there are various commonly used metrics that are all are valid for different reasons. A financial instrument’s liquidity can be measured as the total volume traded / turnover, the volume of orders sitting on the order book at a given point in time, as well as by the bid-ask spread. Although financial instruments can generally be categorised in liquidity baskets ranging from highly liquid to highly illiquid, it is important to note that liquidity is not fixed and may vary over time due to changes in market sentiment or as a result of specific events.
The presence of market makers, also called liquidity providers, increases the liquidity of the market in a given financial instrument. A market maker continuously posts quotes – both bids to buy and offers to sell – and thereby provides liquidity to the market.
What Does Liquidity Mean for the Markets?
The more liquid the market in a given financial instrument is, the higher the trading activity and the easier it is for a market participant or end investor to buy and sell that instrument. A liquid market reduces the risk of not being able to find a counterparty to trade with or having to buy at a high premium or sell at a large discount, so there is a direct impact on transaction costs. As a result, liquid markets are in higher demand among investors which in turn attracts more supply from market makers that compete with each other, leading to further narrowing of bid-ask spreads.
- Blue-chip shares – shares of well-established companies with large market capitalisation – generally receive a lot of demand and supply interest and are therefore very liquid. For example, one of the most traded stocks is Apple Inc. with an average daily dollar volume of +/- $15 billion. If an investor wishes to buy or sell Apple shares the order will likely be executed quickly at a stable price. In contrast, small caps – shares of companies with a small market capitalisation – attract less investor interest and are typically illiquid. Trading volumes can be expected to be much lower, making it more difficult for the end investor to get out of or into a position (or more simply put – buy or sell an instrument).
- Liquidity can also differ between two listings of the same company. Imagine a medium sized Dutch company that has a primary listing on the Dutch market and has a secondary listing on a foreign exchange. The majority of trading occurs on its primary listing, where it is very liquid and has a high average daily volume traded. In contrast, there are very few participants actively trading the instrument on the foreign exchange. Trading activity is very low or even non-existence on some days. This lack of liquidity increases risk for participants trading on the foreign exchange, as it may mean they are forced to trade at unappealing prices.