If a market is being traded regularly then it is said to be liquid, or to have high liquidity. This is because the volume of buyers and sellers in the market creates a free flow of trade, as there’s always someone willing to take the other side of a given position.
In a liquid market, a seller will quickly find a buyer without having to cut the price of the asset to make it attractive. And conversely a buyer won’t have to pay an increased amount to secure the asset they want.
If there are only a few buyers and sellers in the market, trading infrequently, it is said to be illiquid, or to have low liquidity.
How does liquidity affect traders?
An asset’s liquidity is a key factor in determining our spreads as a provider of leveraged trading.
High liquidity means there are large numbers of orders to buy and sell in the underlying market. This increases 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 spread will normally tighten.
As we derive our prices from those in the underlying market, a lower bid-offer spread here will usually translate into lower spreads offered on the platform.
Spreads can narrow even further during periods where it’s easier for us to hedge in a relatively liquid market. Because hedging costs are lower, this can be reflected in lower fees being passed on to the clients.
The most liquid and illiquid markets
Some of the tightest spreads are found in forex pairs. Forex is considered the most liquid asset in the world due to the high volume and frequency with which it’s traded. So you’ll usually see very narrow bid-offer spreads for major currency pairs such as EUR/USD, GBP/USD or USD/JPY.
On the other hand, spreads for less liquid assets, such as small-cap stocks (generally a company with a market capitalisation of $50 million to $400 million), will tend to be significantly wider.