When trading, market liquidity offers a measure of how quickly an asset can be converted to cash. The more market liquidity an asset has, the more easily it can be traded for cash. This comes into play when looking at its price point: the more tradable an asset, the less impact the trade will have on the asset's price.
Other factors to look out for include trading volume, technical indicators, and volatility. Liquidity is important for everything across the stock market and digital asset market to a company's liquidity, with liquid assets always being preferable. Let's first take a look at what liquidity is, the most liquid assets and the key takeaways liquidity refers to.
What does liquidity mean, exactly?
In its simplest form, liquidity looks at how easily and quickly an asset can be converted to another asset (bought or sold) without affecting its price. Liquidity can also sometimes be referred to as a cash ratio or marketable securities. A liquidity ratio helps investors determine whether something is a liquid asset or not and how easy it will be to convert assets.
When an asset has good market liquidity, this means that it can easily be traded for cash or other assets with no effect on the asset's market price. Referred to as liquid assets, these would include currencies, marketable securities, and money market instruments. This provides peace of mind to investors that have other financial obligations.
On the other hand, low liquidity means that the asset cannot be as easily bought or sold and any transaction that takes place will affect the asset's trading price. Real estate, rare items, and exotic cars present examples of illiquid assets, meaning that they may take longer to be sold, and not necessarily at the price the seller is expecting to receive.
What is the most liquid asset?
In terms of financial liquidity, cash is considered to be the most liquid asset.
Think of liquidity as a spectrum - on the one hand, you have cash (highly liquid) and on the other, you have rare items. Consider where on the spectrum an asset might fall to get an idea of its liquidity.
Types of liquidity
In a general sense, there are two types of liquidity: market liquidity and accounting liquidity used to measure the current ratio of an asset or company.
What is market liquidity?
The first of the two types of liquidity is market liquidity, defined as the ease with which a financial asset may be bought and sold at fair prices. These are the prices that are most similar to the assets' actual value, known as their intrinsic value.
Intrinsic value in this case refers to the lowest price a seller is willing to accept (ask) and the highest price a buyer is willing to pay for it (bid). The bid-ask spread, also known as the trading spread, is the difference between these two values. The lower the bid-ask, the greater the liquid asset.
What is accounting liquidity?
Accounting liquidity describes a company's ability to pay its short-term debts and liabilities with its current assets and cash flow. In other words, it reflects the company's financial health: the higher the company's accounting liquidity the more liquid the company's capital.
Most commonly, you'll hear accounting liquidity mentioned in relation to businesses and their balance sheet. This has less to do with liquid assets and more to do with businesses, and the company's financial health, as a whole.
What is a bid-ask spread?
The bid-ask spread refers to the difference between the highest bid and the lowest ask price. As you would expect, a low bid-ask spread is preferred in liquid marketplaces. It implies that the market has sufficient liquidity since traders continuously bring the high and low prices back into balance.
A wide bid-ask spread, on the other hand, generally indicates illiquidity in an asset and a substantial gap between what buyers are willing to pay and what sellers are willing to accept.
The bid-ask spread plays a valuable role for arbitrage traders as they attempt to take advantage of minor disparities in the bid-ask spread over and over again.
While they make money, their activities help to support the market as they reduce the bid-ask spread, and other traders will have better trade execution as a result of their activity.
Arbitrage traders also make sure that the same market pairs do not have significant price disparities on various exchanges. Have you ever seen how the Bitcoin price is roughly similar across the most liquid markets? This is due in large part to arbitrage traders who exploit small variances between prices on different exchanges to profit.
Why liquidity plays an important role in the markets
Bigger stocks and digital currencies tend to have more liquid markets due to their higher trading volume and market efficiency.
The amount of money traded per day, otherwise known as liquidity, varies depending on the market. For example, some markets may only have a few thousand dollars of trading volume while others have billions.
Assets from large companies or establishments don't usually have issues with liquidity since there are many buyers and sellers in their respective markets. However, this isn't the case for less traded assets which often lack significant liquidity.
When building your portfolio ensure that you incorporate (or stick to) liquid markets so that you can always know that should you wish to liquidate the asset you will get a good price. Sometimes with smaller assets, you might not be able to exit the market at your desired price leaving you with an invaluable asset or one traded at a significantly lower price.
This is known as slippage and can result from trying to fill a large order in an illiquid market. Slippage is the difference between the price you intended to sell at and at what price your trade is actually executed.
High slippage indicates that your transaction was completed at a significantly different price than you intended. This usually occurs because there aren't enough orders in the order book near to where you wanted to execute them. This can be avoided by only using limit orders, but this runs the risk that your order may not be filled.
The market conditions significantly affect liquidity. For example, in a financial crisis, different traders might respond by either selling their assets or withdrawing cash.
Final thoughts
When it comes to the markets, liquidity refers to the ease of trading in a market. Traders often favor liquid markets because they provide convenient access for entering and exiting positions. The level of liquidity can influence the efficiency and effectiveness of trading strategies. Depending on your preferences, you might consider including highly liquid assets in your portfolio, which can have benefits in terms of flexibility.
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