What Is Liquidity in Stocks?

Liquidity is an important factor for investors to consider when building a portfolio. But what is liquidity in stocks? Liquidity refers to how easily an investment can be converted back into cash. Understanding how to achieve liquidity in your portfolio and why it’s important will help you mitigate against risk and be more likely to achieve financial success.

How Does Liquidity in Stocks Work?

Liquidity is used to describe how quickly a stock or other investment can be sold. A stock that can be bought and sold at any time would be considered extremely liquid because it can be sold and turned into cash. An investment that cannot be easily sold would be considered illiquid. 

Some investments are more liquid than others. Many stocks can be easily bought and sold through brokerage platforms during market hours. Other investment vehicles, like bonds, are less liquid. They have set time horizons and cannot be sold until the investment term. That means the cash invested cannot be accessed until the set period is over.

Why Liquidity Matters in Stocks

Why is it important to have a good level of liquidity in your stock investments? Liquidity helps mitigate against risk and can boost overall performance. For example, if you have an investment that is performing well and has risen in value, you might want to sell it before it decreases in value. But if your investment is illiquid, you won’t be able to sell, which could potentially impact your ability to achieve gains.

Liquidity can also be an indicator of a stock’s performance. If there’s high demand for a stock, it’ll be pretty easy to sell and show that the company is doing well and the stock is valuable. Low liquidity is typically a signifier of market instability.

When building a portfolio, stock liquidity is important for many reasons. First, it allows you to easily cash in on your stocks, which can be important if you experience economic instability. Additionally, high liquidity also means strong market and stock performance.

How to Assess Liquidity in Stocks

Liquidity is important, but how is it measured? There’s no exact way to calculate stock liquidity, but there are a few factors that you can evaluate to determine liquidity level. 

Key Indicators to Consider

Investors should keep a few main indicators that investors in mind when determining liquidity. These indicators include trading volume, bid-ask spread, market depth and order book visibility.

• Trading volume: Trading volume refers to the amount that stock has been traded over a certain period. If the trading volume is high, that means there is a lot of interest in that stock. Interest can also be an indicator of demand, and increased demand for a stock means it’ll be easier to sell and is more liquid.
• Bid-ask spread: The bid-ask spread of a stock is the difference between the amount a buyer is willing to pay for a stock (the bid) and what the seller is willing to sell for (the ask). When the spread is narrower, meaning the difference between the bid and the ask is smaller, the stock is considered more liquid because it is easier to sell. When the spread is larger, it will be harder to sell.
• Market depth: Market depth measures liquidity by looking at standing orders to buy and sell. Strong market depth would allow these orders to be filled without heavily impacting the stock’s price. For an investment to be considered liquid, it needs to have a strong market depth because that indicates an ease in buying and selling.
• Order book visibility: Order books are records of all trades of a certain stock. They show all bids and asks for stock. When the order book is visible to the public, investors can research how many outstanding bids and asks there are and determine the bid-ask spread. It’ll provide the information needed for investors to determine liquidity and see how many trades have been fulfilled.

Tools and Resources for Analyzing Liquidity

To analyze stock liquidity, you’ll want to first look at the stock’s chart. The chart can show you the price range, overall trends and trading volume. High volume indicates high demand, which makes it easier to buy and sell a stock. You can also determine the bid-ask spread by subtracting the asking price from the bid price. 

Further financial analysis, such as looking at current, quick and cash ratios, can also help determine liquidity. If a stock and company are performing well, are stable and have high trading volume, investors will be more likely to sell their shares with ease.

Benefits of Investing in Liquid Stocks

Investing in liquid stocks has many benefits, from capitalizing on returns to mitigating risk.

• Higher liquidity and ease of buying or selling: If your stock is performing well and you want to cash out, you’ll need to easily sell your stocks. Liquid stocks allow you to sell at a moment’s notice so that you can optimize returns or cash out in case the funds are needed elsewhere. It also allows you to easily rebalance your portfolio as needed.
• Reduced risk of slippage: Slippage is when the bid-ask spread changes between the time an investor initiates a trade and the trade occurs. Liquid stocks tend to be more stable in their prices, supported by steady supply and demand. This price stability reduces slippage, so investors can be more confident in their trades.
• Enhanced price discovery: Price discovery refers to how the market determines an asset’s price. Liquid stocks that are more stable in price allow for easier price discovery, so investors can trust the prices listed. 
• Attraction for institutional investors: Liquid stocks are great for institutional investors because they allow investors to buy shares at the lowest possible price and sell them for higher. Things can change quickly in an institutional environment, and liquid stocks allow investors to buy, sell and rebalance portfolios whenever needed.

Risks and Pitfalls of Illiquid Stocks

Illiquidity in stocks can cause several risks within a portfolio, which can affect overall returns. Here are just a few of them:

• Limited trading activity and low volume: Many illiquid stocks have low volume and aren’t being traded regularly. This means it’ll be harder to buy and sell shares when you need to. 
• Impact on bid-ask spread and transaction costs: Illiquid stocks typically have a larger bid-ask spread. This means you’ll have less flexibility in setting the price you want to buy or sell a share. For example, if you’re trying to sell a share at a price higher than the bid price, you might struggle to find a buyer because demand is low. You could end up selling your shares for less than ideal or paying more to buy.
• Difficulty in executing large orders: Illiquid stocks have low volume and low supply and demand, making it difficult to conduct trades with many stocks. There may not be enough supply for you to buy a large amount of shares. If you’re selling, there may not be enough investors looking to buy a large amount of shares. It’ll increase transaction costs and make it much harder to make large moves.
• Potential price manipulation: Because illiquid stocks don’t have a lot of trading activity, it makes it easier for people to manipulate the price of an asset. Liquid stocks have a lot of activity, making it hard for one person or a group of people to influence the price. An illiquid stock is pretty stagnant and can make it much easier for a small group of people to greatly manipulate the price for their own gain.

Liquidity and Market Efficiency

The stock market works most efficiently when there are high amounts of liquidity. Liquidity allows the market to function as intended, with there being high volumes of trading that determine the price of assets. Liquidity provides people flexibility and can show the unhindered natural progression of the market. If the market is liquid, it also means there are a high number of investors making moves, which can show confidence in the market. If the market begins to become less liquid, it means investors are hesitant to buy or sell. Liquidity means activity, which tends to show confidence in the economy and the market.

Liquidity also helps stabilize stocks. When more trades are occurring, individual trades become less impactful. That means people can freely buy and sell without affecting the prices of individual stocks or markets too much. When liquidity falls, it means there’s less activity. And when there’s less activity, one trade has more influence, which can cause instability in the market.

Achieve Liquidity in Your Portfolio

By having a strong level of liquidity in your portfolio, you’ll mitigate risk and optimize your chance for returns. Liquid stocks are stable and allow you to rebalance your portfolio as needed. Liquidity will increase your chances for returns so that you are one step closer to meeting your financial goals. If you have more questions about finding liquid investments, consult your financial adviser for personalized advice and investment strategies.

Frequently Asked Questions