If you’re buying popular stocks on the New York Stock Exchange or NASDAQ, you probably aren’t thinking too much about your order execution. It happens instantly at the price your broker quoted you.
However, this quick and predictable trade execution depends on something known as liquidity. Popular stocks tend to have high liquidity, but not every stock does. Without sufficient liquidity, the process of buying or selling stocks can be much more difficult.
So, what is liquidity and how do you know if a stock has enough of it for seamless trading? In this article, we’ll explain everything you need to know about liquidity in the stock market.
What is Liquidity?
Liquidity is a characteristic that describes how readily a stock can be bought or sold without affecting its price. At its heart, liquidity is a measure of supply and demand.
When a stock has high liquidity, you can buy or sell it nearly instantly at the current market price. There are plenty of shares being sold in the marketplace and plenty being bought. So, buyers have no problem finding a seller who is willing to sell at the current market price and sellers have no problem finding a buyer who is willing to buy at the current market price.
On the other hand, when a stock has low liquidity, there may not be enough supply of or demand for shares. If you’re trying to sell a stock, for example, you may not be able to find ready buyers. You might have to sell some shares to one buyer at the current market price, and the remainder to another buyer at a lower price. So, as your trade progresses, the price of your shares is changing in response to the trade itself.
Why Is Liquidity Important?
Liquidity is essential to the functioning of the stock market as a whole and to individual stock trades. Let’s take a look at some of the key impacts that liquidity has on stocks.
Fast Trade Execution
High liquidity is critical to enabling you to get in and out of trades quickly. With sufficient liquidity, you can instantly or nearly instantly buy shares at one price and sell them at another price.
When liquidity is low, though, you might not be able to buy or sell shares quite so easily. Since buying and selling activity is low overall, it could potentially take several minutes or longer for someone to accept your offer to buy or sell shares. That’s a big problem for intraday trading, when trade speed often makes the difference between a profit and a loss.
Lower Volatility
Liquidity also affects how volatile a stock’s price is. Highly liquid stocks tend to be less volatile because the price changes in small increments. There are tons of buyers and sellers, so raising or lowering a stock’s price by a few cents is typically enough to spur trading activity.
When liquidity is low, stock prices can be very volatile. To offer an extreme example, say you’re selling a stock for $50, but the only buyer in the market is offering $45 for it. Reducing the price by a few cents won’t help you sell your shares if no other buyers are present. Your only option is to drop your sale price to $45 – a 10% change in the current market price for that stock.
Market Efficiency
High liquidity is also important for running an efficient market – that is, a market where prices reflect all available information. When there’s plenty of liquidity, shares can readily change hands and prices can move in response to new information.
When liquidity is low, new information won’t necessarily change the price of a stock. If there are only a few buyers and sellers, they may react to information differently and come up with divergent price estimates. This can prevent transactions from taking place at all, so the market price doesn’t reflect the ‘real’ value of a stock based on all information.
How to Gauge Liquidity
Liquidity isn’t a single number. Rather, it has to be estimated in terms of other indicators.
Trading Volume
The best way to gauge liquidity is by looking at daily trading volume. You can look at the number of shares trading hands as well as the number of trades taking place. While there’s no specific dividing line between high- and low-liquidity stocks, stocks that typically see at least 500,000 shares traded per day are considered high liquidity.
You can get an even better look at liquidity by comparing the day’s trading volume to the 10- or 50-day average trading volume. If volume is unusually high or low, liquidity may be unusually high or low as well.
Float
Another thing to consider is a company’s float. This is the number of outstanding shares that are available for public trading. The float doesn’t count shares that are held by insiders or institutional investors and that is restricted from trading.
A high float doesn’t necessarily mean liquidity will be high, since floating shares aren’t necessarily up for sale. However, if the float is low, liquidity is likely to be low as well.
Bid-ask Spread
You can also get a sense of a stock’s liquidity by looking at the bid-ask spread. This is the difference between the price that you can buy a stock for and the price that you can sell it for at any given time.
When the bid-ask spread is wide, it’s a sign that liquidity is low. When the spread is narrow, it’s a sign that liquidity is high.
Conclusion
Liquidity describes how readily a stock can be bought or sold without affecting its price. It plays a critical role in the stock market and impacts everything from how quickly your trades are executed to how volatile a stock’s price is. Although liquidity can’t be measured with a single number, you can gauge liquidity by looking at a stock’s trading volume, float, and bid-ask spread.
