Liquidity describes the extent to which an asset can be bought and sold quickly, and at stable prices, and converted to cash.
Liquidity refers to how quickly and at what cost one can sell an asset, whether that is a financial asset such as a stock or a real asset such as a commercial building.
If one has an asset whose “true,” or fundamental, value is $100, and one can instantly convert that asset into $100 of cash or cash equivalent, then we think of the market for that asset as perfectly liquid.
Of course, such a perfectly liquid market is rarely observed in the world.
Liquidity is also used to measure how quickly a buyer of an asset can convert cash into that tangible asset.
So in a perfectly liquid market, someone who is looking to buy an asset whose fundamental value is $100 will be able to purchase that asset instantly for exactly $10 and receive it instantly.
It is a measure of how many buyers and sellers are present, and whether transactions can take place easily.
Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market.
Liquidity is considered “high” when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller.
If there are only a few market participants, trading infrequently then liquidity is considered to be “low”. This is known as an illiquid market.
Why is liquidity so important?
Market liquidity is important for a number of reasons, but primarily because it impacts how quickly you can open and close positions.
A liquid market is generally associated with less risk, as there is usually always someone willing to take the other side of a given position.
This can attract more traders to the market, which adds to the favorable market conditions.
In a liquid market, a seller will quickly find a buyer without having to reduce the price of the asset to make it more attractive. On the flip side, a buyer won’t have to raise the price to get the asset they want.
An asset’s liquidity is also a key factor in determining the spread that a trading platform or broker provides.
High liquidity means that there are a large number of orders to buy and sell in the market. This increases the probability that the highest price any buyer is happy to pay and the lowest price any seller is happy to accept will move closer together.
In other words, if a market is liquid, the bid-offer spread will tighten.
If a market is illiquid, the bid-offer spread will widen.
What causes illiquidity?
There are two frictions that lead markets to be less than perfectly liquid, or illiquid.
The first is an indirect cost. There is the possibility that it takes some amount of time before the conversion of the asset into $100 of cash takes place.
For example, we may have to take the asset to a market, or if we are at the market, we may have to wait until someone comes along who wants the asset.
This waiting time, sometimes referred to as a waiting cost or search cost, is one manifestation of illiquidity, and it makes a market less than perfectly liquid.
The second friction is a direct cost.
We may decide to pay someone a fee to get the asset sold immediately. Rather than paying the indirect cost of waiting until finding someone who will pay us the full $100 of cash, we may choose instead to cut our waiting time to zero and simply pay someone else, a “dealer,” to do the waiting for us.
We are essentially paying the dealer for transaction immediacy, or liquidity.
This cost is known as a transaction cost or liquidity cost. But more commonly known as the “bid-ask spread” or “spread.
For example, we may sell the asset to a dealer for $99.00 and let the dealer then worry about waiting to find someone who wants this asset.
In this case, the dealer is providing us transaction immediacy in exchange for a fee of $1.00.
While we have cut the waiting cost to zero, this is not a case of perfect liquidity because we have to pay a fee.
While a dealer is a commonly used term for someone who provides such transaction immediacy (or liquidity) services in the financial markets, terms such as principal, financial intermediary, and broker are also used.
In the financial markets, financial institutions such as investment banks typically act as dealers for investors.
How to use liquidity in trading
When you’re trading financial markets, liquidity needs to be considered before any position is opened or closed.
This is because a lack of liquidity is often associated with increased risk.
If there is volatility on the market, but there are fewer buyers than sellers, it can be more difficult to close your position.
In this situation, you could risk becoming stuck in a losing position or you might have to go to multiple parties, with different prices, just to fill your order.
The most important thing to remember is that market liquidity is not necessarily fixed, it’s dynamic, constantly shifting from high liquidity to low liquidity.
Whether current liquidity is high or low depends on a variety of factors such as the volume of traders and time of day.
If you are trading a market out of hours, you might find that there are fewer market participants and so the liquidity is much lower.
For example, there might be less liquidity on CHF currency pairs during Asian trading hours. Compared to European trading hours, the spreads would be wider.
Forex is considered the most liquid market in the world due to the high volume and frequency with which it’s traded.
So in the forex market, liquidity pertains to a currency pair’s ability to be bought and sold without causing a significant change in its exchange rate.
A currency pair is said to have a high level of liquidity when it is easily bought or sold and there is a significant amount of trading activity for that pair.
Despite having high levels of liquidity, the forex market does not exhibit stable pricing.
The amount of people trading major pairs leads to diverse views on what the price should be, which leads to daily price movements.
This is especially true when the news is being digested by the market.
The major forex pairs, the most popularly traded pairs, are the most liquid.
This means that pairs like EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD experience high liquidity.
In forex, liquidity matters because it tends to reduce the risk of slippage, gives faster execution of orders, and tighter bid-offer spreads.