Market liquidity in trading refers to the easy flow of securities between traders or investors. When considering the concept of ease in trading, there are two factors which are particularly important. One is time. Once a trader makes the decision to buy, or to sell a security, he or she generally wants this to be executed in as timely a manner as possible. The other factor is price. When there is ease of trading, this entails the seller of the security being able to attain the price which is at, or near, what they are asking.
How is Liquidity Assessed?
Volume is a good indicator of the speed at which securities are changing hands, and therefore is an important component of assessing liquidity. When there is a large amount of trading which is balanced between buying and selling, and not showing a disproportionate amount of selling, this indicates a stock that is flowing easily, and as such may be described as highly liquid. With a liquid stock there should be little or no time lag between one investor wanting to sell, and another wanting to buy.
Another primary measure of the market liquidity of a security is found in the bid-ask spread. This refers to the gap between what a buyer is offering, and what a seller is asking. When the price that is being asked is fairly close to the price being offered, this indicates higher liquidity. The stocks are able to change hands not only rapidly, but at a price which will not cause great movement in the value of the stock. Conversely, when there is a wide gap between the bid and ask prices, this indicates lower liquidity, or sluggishness in the movement of the stock.
In options trading, open interest is also a measure of liquidity. Open interest refers to the number of existing options contracts on a particular security that have already been entered into, and not yet closed or exercised. The selling of previously established options contracts to another trader or investor does not change the level of open interest, as no new options contracts have been created. The level of open interest changes when positions are closed or new contracts are created. The more contracts are being created, showing greater interest in the security, the higher the liquidity of the options contracts is considered to be. Data on open interest levels is available from The Options Clearing Corporation.
The Importance of Market Liquidity to Traders
High liquidity of a security provides an indication of high demand and turnover. It does not guarantee that a trader will be able to exit a trade quickly when they decide to do so, but it does give a much higher probability that this will be possible. It also improves the chances that in the event of the price turning against the trader, a stop-loss order will promptly be able to be executed at the price specified.
When entering trades, a liquid market in options trading offers greater choices of strike prices, expiration dates, allowing a trader to execute the strategies they wish to undertake more easily.
Liquidity also provides greater likelihood of being able to attain the desired price at the desired time, with a narrow bid-ask spread meaning that there are traders ready and willing to pay close to what others are asking.
If you are a buy and hold investor, then liquidity in stocks may not have particular relevance to you, but for those engaged in trading within the stock market, and particularly options traders, liquidity is a very important consideration when entering into any positions.