A market’s liquidity is the ease with which it can be bought or sold without affecting its price. It’s an important factor to consider when trading financial markets – opening and closing a position on a highly liquid market is easier and generally less risky than on an illiquid one.
When traders talk about a market with high liquidity, they usually mean that it is being traded by a large number of people at any given time.
If an asset or group of assets are being heavily traded on the market, liquidity will generally be high as it will be much easier to find a buyer (or seller) for that asset – as long as there aren’t any restrictions on supply.
The most liquid asset is usually cash, because there is an abundance of people willing to exchange your cash for other assets. An investor with £10,000 cash, for example, would find it easier to put his cash into an investment fund than someone with £10,000 in bonds.
Example of a liquid market
Shares in a blue chip stock, such as Apple, can also be highly liquid. Take a look at the trading volume for Apple shares and you’ll see thousands of investors buying and selling shares on any given trading day. This helps to ensure that you’ll be able to buy and sell Apple stock easily – and unless you are trading in large numbers of shares, you shouldn’t impact Apple’s share price too much.
Example of an illiquid market
Penny stocks, on the other hand, can be relatively illiquid. With less trading volume on any given trading day, an investor with a large number of shares in a penny stock might find it hard to find a buyer if they want to sell – and they might be forced to sell at a worse price than they anticipated.
What is liquidity risk, and how can it affect me?
Liquidity risk is the potential that a lack of liquidity will result in you having to open or close a position at a worse level than the current market price. Liquidity risk can affect your trades in a number of ways, but there are two key examples: