Explained: Why Market Liquidity Is Important

12

April, 2019

AK Equity Group

What is market liquidity and why is it important?

Market liquidity affects a range of crucial trading factors, from the bid-offer spread to trade execution. In relation to the market, the term “liquidity” refers to the extent to which an asset can be bought and sold quickly, and at stable prices. Put simply, it is a measure of how many buyers and sellers are currently present in the market, and whether trades can be executed easily.

Generally speaking, high levels of liquidity occur under the following market conditions:

  • There is a significant level of trading activity, and
  • There is both high supply and demand for an asset

Under these conditions, it is generally easier to find a buyer or seller, making the market more liquid. If there are only a few participants in the market, and they are trading infrequently, that market will be described as “illiquid.”

Why is market liquidity important when investing?

Market liquidity is important for a number of reasons, but primarily because it impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as there is usually always someone willing to take the other side of a given position. This can attract investors to the market, which adds to the favourable market conditions.

In a liquid market, a seller can quickly find a prospective buyer without having to reduce the asset’s price in order to make it more appealing to the buyer. Likewise, the buyer typically won’t have to pay a hiked-up price to acquire the asset they want.

The liquidity of an asset is also an important factor in influencing the spread that a leveraged trading provider can offer. High liquidity comes from the presence of a large number of orders to buy and sell in that particular market. This market condition increases the chance that the highest price a buyer is willing to pay and the lowest price a seller is prepared to accept will move closer together. In this scenario, we say that the “bid-offer spread” has tightened. In illiquid markets, there is typically a much wider bid-offer spread.

Liquidity in trading

Liquidity is important for anyone trading in financial markets, because a lack of liquidity typically correlates to increased risk. This factor should be considered before opening or closing any position.

Under volatile market conditions, specifically if there are fewer buyers than sellers, it could potentially be more difficult for you to close your trading position. In this scenario, the risk is that you could become stuck in a losing position.

Market liquidity is not necessarily a fixed feature; it can ebb and flow dynamically, depending on a variety of factors, such as volume of traders or even the time of the day.

If you are trading an overseas market, which operates in a different time zone, you need to consider when the peak trading hours occur in different geographical areas. For example, there might be less liquidity on GBP forex pairs during Asian trading hours. This could lead to wider spreads and lower liquidity than during the European trading hours.

The bottom line is that a lack of liquidity can result in unfavorable prices for buyers, or difficulty selling assets at a good price for sellers. Liquidity is a crucial factor to consider when investing, particularly for how it can shape and influence risk in a given market scenario.

Related