What is market liquidity and why is it important?

Market liquidity impacts everything from the bid-offer spread to trade execution. That’s why it’s important to have a firm understanding of what the term means, and which markets are liquid and illiquid.

Trader Source: Bloomberg

Market liquidity explained

Liquidity describes the extent to which an asset can be bought and sold quickly, and at stable prices. In simple terms, 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.

High levels of liquidity arise 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, it is said to be an illiquid market or to have low liquidity.

Liquidity leads to lower spreads and faster and easier trading

Liquidity leads to lower spreads and faster and easier trading

Why is market 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 speculators and investors to the market, which adds to the favourable market conditions.

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.

An asset’s liquidity is also a key factor in determining the spread that a leveraged trading provider – such as IG – can offer. High liquidity means that there are a large number 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 bid-offer spread will tighten.

As we derive our prices from those in the underlying market, a lower bid-offer spread here will translate into lower spreads offered on the platform. If a market is illiquid, it could mean that there is a much wider spread.

How to use liquidity in trading

When you’re trading financial markets, liquidity needs to be considered before every 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.

One way to manage liquidity risk is through the use of guaranteed stops, a type of stop-loss that ensures your position is closed at your pre-selected price level. Guaranteed stops are not impacted by volatility, so can be a useful tool for navigating tumultuous markets. If your guaranteed stop is triggered, though, there would be a small fee to pay.

The most important thing to remember is that market liquidity is not necessarily fixed, it works on a dynamic scale of high liquidity to low liquidity. A market’s position on the spectrum depends on a variety of factors such as the volume of traders and time of day.

If you are trading an overseas market, or 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 GBP forex pairs during Asian trading hours. This could lead to wider spreads than during the European trading hours.

What are the most liquid markets?

  1. Forex (major pairs)
  2. Large-cap stocks
  3. Commodities

Although these are three of the most liquid financial markets, cash is actually the most liquid asset because it can be used to buy just about anything. Therefore, the liquidity of most other assets is judged by the speed and ease at which they can be converted into cash.

Forex and liquidity

Forex is considered the most liquid market in the world due to the high volume and frequency with which it’s traded.

Governments, all major banks, insurance companies, investment houses, traders and even individuals going on holiday all contribute to the vast amount of trades that take place on the forex market daily. It is estimated that more than $5 trillion are traded on the forex market every day.1

Despite experiencing high levels of liquidity, the forex market does not exhibit stable pricing. The amount of people trading major pairs leads to differing opinions about what the price should be, which leads to daily price movements. This is especially true when news is being digested by the market. Although it creates high levels of volatility, the prices are usually kept within a range and trade in smaller increments.

It is generally assumed that the major forex pairs – the most popularly traded pairs – are the most liquid. This means that pairs like EUR/USD, GBP/USD or USD/JPY 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.

Large-cap stocks and liquidity

For a stock to be considered liquid, its shares must be able to be bought and sold quickly and with minimal impact to the stock’s price. According to Canadian regulators, a liquid stock is classified as one that is traded at least 100 times per day and has an average daily trading volume of at least $1 million.2

The shares of companies that are traded on major stock exchanges tend to be highly liquid. These are known as large capitalisation, or large-cap, stocks.

To qualify as a large-cap stock, a company typically needs to have a capitalisation of $10 billion or more. They are also normally blue-chip stocks, which have established earnings and revenue. Conventional theory suggests that companies with larger market caps are more likely to have stable prices and a higher volume of traders, which means that the shares can be converted to cash relatively quickly.

Commodities

The accessibility of a market is linked to its liquidity. Traditionally, commodity markets were considered significantly less liquid than other markets because the physical delivery of assets made them difficult to speculate on. But thanks to the rise of derivative products – including CFDs, futures, ETFs and ETNS – it is easier to trade commodities than ever before.

There are different degrees of liquidity depending on which commodity you are looking to trade. The most frequently traded commodities are generally the most liquid, such as:

  • Crude oil. Perhaps the most highly traded commodity in the world is crude oil due to its vast number of applications and the number of ways that you can trade it
  • Precious metals. The most liquid precious metal is gold as it experiences the highest level of trading volume, and there are a vast number of different products available that can be used to trade the market
  • Sugar. As the most popular ingredient in our diets, sugar has also become one of the most widely traded markets. At one point, it was even known as ‘white gold’

What are the most illiquid markets?

  1. Exotic forex pairs
  2. Small-cap stocks

Exotic forex pairs and small-cap stocks are among the most illiquid financial markets, though there are many others. The most illiquid investment market is real estate, due to the sheer amount of time that the process of buying and selling property takes.

Exotic forex pairs and liquidity

Exotic currency pairs comprise of a major pair being traded alongside the currency of a developing or emerging market – such as the Mexican peso, Hong Kong dollar or the Turkish Lira. By definition, exotic pairs are more thinly traded, which means that they have far less liquidity when compared to the major pairs.

This is largely because there are so few market participants that trade exotic pairs, so there is little disagreement over the fair market price. This means that when something changes, there is normally a consensus of opinion and the price easily adjusts as a response – this can often create extreme price swings.

The lack of liquidity means that the bid-offer spread is usually far wider, and there is a general lack of information available about exotic pairs.

Small-cap stocks and liquidity

Small-cap stocks are those that have market capitalisations of between $300 million and $2 billion and are listed on smaller stock exchanges. They are typically associated with low levels of liquidity and greater risk.

Small-cap stocks are not traded as frequently, which means that when there is a demand for their shares, it can have a massive impact on the market and create significant volatility.

A lack of liquidity can result in unappealing prices at which to buy the stocks, or a difficulty in selling stocks at a favourable price.

1 NASDAQ, 2019

2 IIROC, 2019

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