Understanding Liquidity in Trading

Anyone active in trading or even mildly aware of the stock market must have heard of the term “liquidity.”

Most of the people hardly understand the term even though they use it frequently.

It is a fairly simple concept even though it is highly misunderstood or less understood.

In this article, we will explain to you the concept of liquidity and why it matters in trading in simple terms. 

What is Liquidity?

Let's take an example to understand the concept of liquidity.

Suppose there is a man who lives in Delhi, the capital of India. He lives in a house which is owned by him.

The man comes from a small village in central India where he owns a house as well.

Now that the family is expanding, he wants to buy another house. For this purpose, he decides to sell the ancestral house in his village.

But the man cannot find any buyer in the hinterland. Meanwhile, he often receives unsolicited offers to purchase his Delhi house.

In the above case, the Delhi house is highly liquid, but the old village house in the town isn’t.

In essence, an asset is considered to be liquid when it can be bought and sold quickly and easily without much difference to its price. 

Since the Delhi house can be sold quickly at a lucrative price, it is highly liquid.

On the other hand, the house in a small village is illiquid because it can only be sold at a low price and will take a lot of time to find a buyer for the purpose.

• A highly liquid asset can be sold in exchange for cash very easily and efficiently.
• In contrast, an illiquid asset takes a lot of time to get sold, that too at a loss. 
   

Cash is considered to be the most liquid asset as it can be exchanged for other assets most quickly and efficiently.

When we talk about liquidity, we are primarily talking about two types of liquidity:

1. Market Liquidity and  
2. Accounting Liquidity

Market liquidity refers to the ease and efficiency with which you can trade stocks in the markets.

A stock on the charts is highly liquid if it has a small bid-ask spread. A spread is the difference between a stock’s asking price and sale price.

Learn more about the bid-ask spread.

Accounting liquidity refers to the ease and efficiency with which a company can pay off its debts with the available liquid assets. 

It is very difficult to trade assets in an illiquid market.

In the example cited above, the house in a small village in central India is an illiquid or a less liquid asset.

There are simply no or very few buyers in an illiquid market. This situation makes it very difficult to sell assets at a reasonable price.

Consequently, the bid (selling) price is very low in comparison to the ask price. An illiquid market has a very broad spread, therefore.

Trading a liquid asset is quite easy in comparison.

Suppose you own a ticket to a Taylor Swift concert, but an urgent matter comes up. You decide to auction the ticket on a social media site and voila, your ticket gets sold without any loss (or maybe, even gaining you a few extra dollars) within a few hours.

If Swift keeps dropping bangers and bangers, Swifties will keep lining up for a concert.

In short, a Taylor Swift concert ticket is going to be highly liquid is most likelihood.  

It is important for traders to learn about both the market liquidity and accounting liquidity of the stock they are investing in.

Liquidity and Bid-Ask Spread

• An asset’s ask demands liquidity.
• Conversely, its bid supplies liquidity.
• An asset’s bid-ask spread rises if there are fewer buyers in the market.
• Conversely, the spread falls if there are a lot of buyers in the market.
• In short, an asset’s liquidity is inversely proportional to its bid-ask spread.
• An asset with a narrow bid-ask spread is demanded the most and is highly liquid.
• An asset with a broad spread is demanded the least and is less liquid.
• A market for stocks, derivatives, futures, bonds etc. is highly liquid.
• On the other hand, markets for debt instruments and OTC stocks are very illiquid. 

Liquidity in Trading

Traders should first consider the liquidity of a stock before purchasing it.

For this purpose, they should observe a stock’s bid-ask spread and daily trading volume.

Let’s take spot Bitcoin (BTC) ETFs for example.

Since their inception in the US in early January, these ETFs have seen daily trading volumes worth billions along with a low spread.  

Looking at these two metrics, we can conclude that spot Bitcoin ETFs are highly liquid — at least, in the recent months.

A highly liquid asset lets you enter and exit a trading position easily and quickly.

This way, you can engage in both short-term and long-term trades for the said stock without a worry. 

What Should BitDelta Traders Know?

We recommend for BitDelta traders to know about both the market liquidity and accounting liquidity of a stock you are interested in trading.

While the former lets them know about the current market dynamics of the stock, the latter lets them assess the financial health of the said company.

It is important for BitDelta traders to understand and learn about the liquidity of their trading portfolio so that they are well aware of any potential risks involved.

A well-read and informed trader makes wise investment decisions even amid any hiccups in the market.

Keep following the BitDelta Academy to learn more about the basics of the financial markets in a detailed yet fun manner.