Defined as the ease by which an asset or security can be converted into cash without affecting its market value, liquidity is a core concept within the financial markets.
Liquidity in trading is important across all asset classes including stocks, forex, crypto and bonds because it helps traders to gain transparency regarding costs, price stability, and the ease of entering/exiting trades.
This article will explore key definitions of liquidity within the financial markets including the metrics used to assess it. Illustrated with real-world examples, this will help traders understand how liquidity works across both global and asset-specific markets as well as the range of depth when trading liquidity in different markets.
What Is Liquidity in Trading? Key Definitions and Why It Matters
Market liquidity is intrinsically linked to price stability, the transactional process, and trading costs. The relative availability of cash on specific markets will impact how efficiently that market operates.
Liquidity in trading refers to how efficiently assets can be converted into ready cash, and bought or sold within the market at stable prices that reflect their true value.
Assets with low liquidity may be more costly to convert and take a prolonged amount of time to sell with potentially volatile pricing. More liquid assets may be readily turned back into cash and bought or sold with faster, more reliable transactions and transparent prices.
Examples of highly liquid assets include major forex pairs, large-cap stocks and exchange-traded funds (ETFs). Illiquid assets include real estate, collectibles and private equity investments.
Liquidity in Trading - How It Affects Execution, Slippage and Costs
Liquidity has a direct impact on spreads, slippage, execution speed and risk.
Illiquid markets tend to have a much lower level of trading activity and wider spreads, meaning greater costs to enter and exit trades. There also tends to be a higher rate of slippage and slower order executions.
Trading on illiquid markets is also associated with a higher level of risk due to volatility and the potential difficulty to quickly exit a losing trade.
In contrast, liquid markets offer very small spreads, low trading costs and low slippage due to the high volume of orders available. Execution speeds are usually (very) fast and reliable with a low level of risk thanks to more predictable, stable price movements. For all of these reasons, traders tend to prefer highly liquid markets.
Stock Market Liquidity - How It Works, With Examples
If we ask “what is stock market liquidity?”, the answer is that it works in the same way as regular market liquidity. This refers to how quickly and efficiently you can buy or sell stock without a big price change.
More active market exchanges with a high level of both buyer and seller activity and tight spreads allow traders to buy and sell high-liquidity stocks quickly and easily at current market prices. However, lower-liquidity stocks may take longer to trade and the impact of buying or selling such a stock can trigger major price swings.
Stocks differ widely in liquidity levels because liquidity on the stock market is measured by a number of factors. This includes trading volume (per day) and the bid-ask spread, where small spread equals active traders, predictable prices and high liquidity while wide spreads mean price disputes and less trading activity for low liquidity.
Liquidity in the stock market is also assessed via market depth, i.e. a deep market sees a high number of buyers and sellers at different price levels while a shallow market (weak liquidity) means far fewer orders and vulnerable pricing.
Liquidity differences are majorly impacted by the popularity of stocks. Large-cap stocks such as Apple and Amazon enjoy high liquidity as they are widely held and frequently traded.
In contrast, smaller companies such as the IMAX Corporation offer small-cap and micro-cap stocks associated with low liquidity because they have far fewer investors and a much lower level of trading activity. This makes their stock highly susceptible to price volatility and wide spreads, resulting in a higher-risk trading environment.
Asset-Specific Liquidity: Forex, Crypto, Bonds and Money Markets
Forex
Typically offering very high liquidity especially among major currency pairs, the forex markets are associated with tight spreads and fast execution as well as low slippage. Forex market liquidity levels are also associated with the high level of activity from many sources (banks, hedge funds, retail traders etc) as well as a 24/5 trading environment. However, liquidity in this market does depend on the pair being traded as minor and exotic pairs are less liquid, making them harder to trade and more prone to slippage.
Crypto
With a lack of centralised marketplace, crypto market liquidity levels vary dramatically depending on the coin being traded. Large-cap tokens such as Bitcoin are relatively liquid but the disjointed nature of the market makes this fairly unpredictable. Smaller altcoins can be highly illiquid.
Bonds
Bond market liquidity firmly depends on the type of bond being traded. Government bonds such as US Treasuries enjoy high institutional demand and a very high level of liquidity, while corporate bonds or small-issuer bonds tend to be much more illiquid.
Money Markets
Money market liquidity tends to be very high, involving assets such as commercial paper and Treasury bills. With the market itself structured for short-term liquidity and a high volume of institutional daily trading, money market trading tends to be completed in large volume with incremental price movements.
Market Liquidity Risk - What It Is and How Traders Manage It
Market and liquidity risk management should be an integral part of any trading strategy. Market liquidity risk is essentially defined as the risk of entering or exiting a position at an unexpected price (i.e. wider spreads and slippage)
Liquidity risk tends to be highest when there's low trading volume and a small pool of potential buyers/sellers. It can also rise during key market events (e.g. economic crisis) and is typically associated with certain types of assets such as small-cap stocks.
There are a number of risk management tools available to traders. Traders may choose lower-risk, higher-liquid assets such as major currency pairs or stocks; they may also limit or adjust position size according to the market conditions/time of day or stagger trades over time.
As with any strategic trading, it’s also important to stay informed about the latest market conditions and any major events via news outlets and economic calendars and attempt to trade during high-volume periods/low volatility conditions. Tools such as limit orders can also be effective.
How to Track Market Liquidity - Tools, Charts and Indicators
Tracking market liquidity can help traders to reduce costs, avoid slippage, find the best price for trades and effectively manage risk.
Volume Charts
Track the number of shares or contracts traded over a minute, daily or hourly time period in line with your chosen strategy. The higher the trading volume, the higher the liquidity (provided the volume is consistent).
Bid-Ask Spreads
Look for narrow spreads to indicate high liquidity and wide spreads for low liquidity.
Broker Tools
Choose a reputable broker that offers access to platforms offering visual liquidity aids via depth-of-market (DOM) tools. Some of the most sophisticated platforms include TradingView and MetaTrader, the latter of which also offers access to charts and indicators to examine liquidity in the forex markets.
Order Book/Level 2 Data
Shows all current buy and sell orders in the market to give key insights into market depth. A thick order book (multiple orders near the current price) indicates high liquidity while few orders signal low liquidity.
Market Liquidity FAQs
What is Stock Market Liquidity?
This refers to how easily and efficiently a stock can be bought or sold without a major impact on its price. A highly liquid stock such as Apple trades millions of shares daily, allowing quick transactions at stable prices. Small- or micro-cap stocks are associated with low daily volume meaning they may take longer to sell and be vulnerable to price swings.
Why is Liquidity in Trading so Important to Understand?
Understanding liquidity helps investors to time and size their trades appropriately as well as choose the assets that best fit with their strategy and desired outcomes.
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