Understanding market liquidity

Understanding market liquidity

This article will help you familiarize yourself with the concept of liquidity. It will also show you how liquidity is measured and what are some of the most liquid and illiquid markets.

Market liquidity is key to understanding how the financial markets work. Usually, assets with good liquidity require a low bid-ask spread, post a small price impact, and show high resilience to various factors (thebalance.com). For these reasons and several others, it is crucial for you to better understand market liquidity as much as possible.

What exactly is market liquidity?

Liquidity measures how easily you can buy or sell an asset without affecting its price. The faster you can sell an asset and closer to its full value, the higher its liquidity. If it takes you a while to sell an asset and must do it at a significantly lower price than the initial one, it means that asset has less liquidity.

Typically, you can calculate liquidity levels by analyzing the volume of trades in a particular market. High liquidity levels occur when trading activity is intense, and the supply and demand for an instrument are significant. Additionally, you can easily find buyers and sellers. Low liquidity levels manifest when trading activity is reduced, and the market players are rare.

What does the market liquidity signal?

Liquidity in terms of trading volume helps traders understand what’s happening with their favorite financial instruments. For example, when an instrument shows reduced trading volumes compared to other similar financial products, it could signal to investors that the demand is low.

And for the other way around: if an asset has significant trading volumes, it is usually a signal for high demand.

An asset class may go through periods where they show higher or lower levels of liquidity. For instance, if you’d want to trade U.S. stocks when the New York stock exchange is not open, you might find it impossible to find buyers. But this does not apply to CFDs. Nothing’s stopping you from trading the assets of your choice. For a full list of instruments, consult our Assets page.

As you can see, time plays a significant role here. How fast you can place a trade and take advantage of high liquidity levels is essential for the rentability of an investment. Still, there are other factors you must take into account as well.

Which are the most liquid markets?

Among the most liquid financial markets, we can mention Forex, stocks, and commodities to a certain degree (especially oil and gold). Some of the reasonably liquid markets include ETFs, indices, and bonds.

In terms of assets, cash posts the highest liquidity. Think about it: you can use cash to buy or sell anything. For this reason alone, the liquidity of most other assets is calculated based on the speed and ease at which they can be converted into cash.

Forex – the No. 1 liquid market in the world

Due to its enormous volume and high trading frequency, the currency market is king in terms of sheer liquidity volumes. According to Wikipedia.com, people traded $6.6 trillion every day on the Forex market (statistics for 2019). That's because everyone from governments, banks, investment funds, and traders contributes to a smaller or more significant proportion.

But not all Forex pairs exhibit significant liquidity levels. In fact, most major ones, such as EUR/USD, GBP/USD or USD/JPY, have proven their liquidity and time again. Minor and exotic pairs aren’t as popular.

Which stocks are the most liquid?

Blue-chip stocks, with larger market cap, earnings, and revenue, are usually highly liquid. Their share prices are more stable due to their premium features; thus, you can convert them into cash faster. Makes sense, right?

Commodities – oil, and gold topple the rankings

From the commodities sector, gold and oil stand out. The reason is simple: oil has numerous uses in day-to-day life, being an indispensable resource for humanity. Gold is the most liquid precious metal (Wikipedia.com) and is also a reliable safe-haven asset.

What about illiquid markets?

A market in which it is difficult to sell assets because of their expense, lack of buyers, or any other reason. Examples of illiquid markets include low trading volume stocks, minor or exotic forex pairs, or less popular commodities. Assets in illiquid markets still have value and, in many cases, very high cost, but are merely tricky to sell.

Conclusion

Market liquidity is a vital concept in the world of financial markets. By fully understanding its implications, you would quickly get in and out of trades rapidly and smoothly with no delays. But to achieve those things, experts advise to closely monitor the liquidity of a stock, currency pair, commodity, index, or any other asset you might be interested in trading.

Curious to learn more about popular trading concepts? Then make sure you stay tuned to our featured articles section!

Sources: Wikipedia.com, investopedia.com, thebalance.com, marketbeat.com

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