A few months ago, when the city was under complete lockdown, and the price of fresh fruits, vegetables, poultry and meat was an all-time high, my next door neighbor decided to satiate all of her husband's junk food cravings by instead buying frozen, packaged foodstuffs… "the price of frozen peas and frozen pre-marinated kebabs is marked on the package and does not fluctuate", she said to me. "It is a better deal right now … the supply is short because borders are closed...demand is exceeding supply and that's why prices are so high," she explained.
Market liquidity is defined as the extent to which a security can be bought or sold rapidly without its price fluctuating much too drastically.
A security is liquid when:
There is high demand and high supply for it
This high demand and high supply translates to a large number of buyers and a large number of sellers
There is a high volume of trading activity.
Liquidity is seen as a largely positive feature in any security, primarily because it is seen to be a sign of less risk. Whatever position a trader chooses - that is whether he chooses to buy or to sell - it is necessary for there to be someone willing to take the opposite position.
For example, if a trader is buying a stock, he wants to be certain that there are lots of buyers on the market for when he wants to sell the stock. He also needs there to be a good number of sellers on the market. Without a good number of sellers in the market, the trade could have to pay an inflated price for the stock he intends to purchase. Similarly, a shortage of buyers for a stock could mean that the trader intending to sell would have to sell at whatever rate is agreed upon by the few existing buyers - in all likelihood he would have to sell at a lower rate than what might be appropriate for the stock, at a deflated rate.
As you may have gathered, market liquidity is absolutely essential for healthy market conditions to be maintained.
Stock traders can manage their risk when it comes to reduced liquidity by employing the use of what is known as a guaranteed stop. A guaranteed stop is a type of stop loss that - as the name suggests - makes a guarantee. The guarantee is that you will close your position at a selected price. For instance you could hypothetically buy a stock at Rs 42 per share and place a guaranteed stop at Rs 45. Or you could hypothetically sell short at Rs 45 and place a guaranteed stop at Rs 42 (for when you want to buy back the stock at a lower rate). If the guaranteed stop is triggered, the trader has to pay a fee.
It is important to note that liquidity is dynamic. Time of day and many other factors influence a stock's liquidity or the lack of it.
Having said that, some markets are by nature more liquid than others.
Let's let's look at some of the typically more liquid markets.
The commodities market in which F&O contracts on Metals, Livestock, Energy (like crude oil and natural gas) and Agricultural produce (like rice or corn) are traded is a food example of a highly liquid market. Among those, gold, sugar and crude oil are seen to be the most liquid.
Large-cap stocks are typically more liquid than small-cap and medium-cap stocks
Third on this list of liquid markets are the more popularly traded forex pairs, such euro:usd, great british pound : usd and usd : Japanese yen.
If some markets are more liquid, it follows that others will be less liquid. Small cap stocks are typically less liquid as are more exotic currency pairs. Don't expect the same kind of liquidity that you get from euro-usd when you have currencies like thai baht or Sri Lankan rupees.
Now you might be thinking: Great! So as long as I invest in liquid stocks, there is no chance of me losing my money because it is not risky. But sorry friend, that's not what we said here. If only it were that simple! What we said, however, is that market liquidity makes for healthy market conditions. Please do differentiate clearly between the two propositions here: Securities that display a higher level of liquidity are easier to buy and sell ….but by no means, does liquidity have anything to do with whether or not a trader is able to earn on a commodity, a stock or a forex pair that displays good market liquidity.
In other words you need to practice risk mitigation measures for securities that display fantastic market liquidity too. You must still only trade with capital that will not cause your life and lifestyle to fall apart, should you lose it. Moreover you must always set a stop loss (no matter how confident you're feeling) and research a specific stock carefully before trading it. Allow me to illustrate with an example: We talked about how large cap stocks typically display high liquidity. However a few months from now a sector-specific issue might dampen the prospects of any and all stocks in that given sector. So in the end, despite being large cap, you may or may not want to trade stocks in the affected sector. As you can see, high market liquidity bodes well for a stock but cannot be the only measure of whether trading it is a sound decision. Practice due diligence.