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Liquidity: How to Find the Right Assets and Markets


November 2021

Liquidity is a common term in the financial world. Market liquidity determines the speed of market operations and an investor's ability to earn money on a specific asset. Financial liquidity allows investors to define securities that can be easily converted to cash. If you've just started your trading path, please slow down for a while and read this tutorial.

What Is Liquidity?

Let's start by unravelling the meaning of liquidity. There are two types of it: Market liquidity and financial liquidity. Liquidity is a common term in the financial world. Market liquidity determines the speed of market operations and an investor's ability to earn money on a specific asset. Financial liquidity allows investors to define securities that can be easily converted to cash. If you've just started your trading path, please slow down for a while and read this tutorial.

What Is Liquidity?

Let's start by unravelling the meaning of liquidity. There are two types of it: Market liquidity and financial liquidity. Market liquidity determines the degree to which a security can be purchased or sold quickly at an acceptable price. Simply stated, liquidity determines how quickly sellers can sell and buyers can buy a specific asset. Financial liquidity determines how quickly and easily the asset can be converted into cash. It's important for investors in real stocks and bonds if we talk about financial markets. It's vital to understand how fast you can convert owned securities into money. If you concentrate on the forex market, financial liquidity is less essential for you.

Market liquidity determines the degree to which a security can be purchased or sold quickly at an acceptable price. Financial liquidity determines how quickly and easily the asset can be converted into cash.

Although the definition of financial liquidity is quite simple, we want to share a life example. Imagine you want to buy a washing machine. If you have cash, you can go to the shop and get a new washing machine. Cash is the most liquid security. If you have a credit card instead of cash, you're more likely to buy the washing machine without any problems as shops accept credit cards.

But what if you don't have cash or credit cards, just shares? Then you'll have to perform some operations on the stock market. Only after that will you get cash to buy the washing machine. Although equity is a liquid asset, it still takes time to exchange it for money.

Now imagine that you don't have cash, cards or shares, but you still need that washing machine. In this case, you'll have to sell something and find a buyer who will accept your price. It'll take even more time to exchange this security for cash. That means that the last asset is the least liquid.

Liquidity: Why Is It Important?

Any trader or investor needs to understand how liquid the market is.  Market liquidity affects many aspects of trading. 

Financial liquidity allows investors to understand how quickly they can convert securities into cash. It's a key point if you want to purchase shares or bonds. Knowing their degree of liquidity, you can be sure you'll get money as soon as you need it.

Market Liquidity vs Volatility 

Liquidity is interconnected with volatility. Both terms relate to market risk. High volatility and low liquidity of assets provide additional risks for traders. Liquidity is interconnected with volatility. 

In times of increased volatility, it's vital for traders to choose a highly liquid market. Imagine you want to sell an asset because the market is fluctuating significantly. However, the market is illiquid, and there are no buyers who can satisfy your order. You can't execute your trade, and the risk of losses increases significantly.

The Most Liquid Markets 

Liquidity occurs in different financial markets. However, the degree of liquidity doesn't directly depend on the market but rather on traded securities. Still, we can highlight the most liquid markets. Let's consider what degree of liquidity you can expect. 

Financial Instruments: High Market Liquidity

As mentioned above, the liquidity of assets differs. So, let's talk about market liquidity. 

Financial Instruments: Low Market Liquidity

Let's consider the securities that may create problems, especially if you're a beginner. 

Assets: High Financial Liquidity

Financial liquidity differs from market liquidity. Financial instruments are supposed to differ, as well. Bonds and stocks have high financial liquidity, as they're easily converted to cash. You should consider the many factors that affect their degree of liquidity, which we'll mention later. These securities are converted to cash with limited efforts.

Assets: Low Financial Liquidity

If you're thinking about such assets as real estate, art, stamps, buildings or coins, you're unlikely to find buyers for them easily. That's why their degree of liquidity will be much lower than those of stocks and bonds. Moreover, if you decide to convert restricted equities, their liquidity is also supposed to be low. 

How to Measure Liquidity

There are two degrees of liquidity. High market liquidity is when there are enough buyers and sellers, and an asset can be easily traded. High financial liquidity is when you can easily convert your asset into cash because there are buyers on the market. Low market liquidity occurs when there are few market participants, and the trade can't be executed. Low financial liquidity means that your asset is rare and unpopular among buyers. 

In common words, liquidity can be calculated using the trades or pending trades volume currently placed on the market. We've covered financial markets in general. Let's consider the most liquid ones and how to measure their liquidity. 

Forex Market

To define liquidity in the forex market, you can apply volumes on the price chart. Volume bars show traders whether the trade is extensive or not. Also, the liquidity of forex depends on the assets you trade. For instance, exotic currencies are among such assets. It's hard to predict their direction; they're highly volatile, so traders avoid such securities.

Liquidity also depends on the market you trade in. Every trader should know about trading sessions. For example, the Asian session starts at 11 pm GMT and ends at 8 am GMT, while the New York (NY) session begins at 12 pm GMT and ends at 8 pm GMT. If you decide to trade Asian assets during the NY session, it's unlikely the market will be highly liquid as major traders won't be there.

Market events are another factor that may provide additional liquidity. In times of significant economic and political events, the number of market participants may increase significantly as fundamental analysis is one option to predict potentially successful trades. For example, a non-farm payrolls report release is always a trigger for traders who want to try their luck, experience and knowledge in the market.

Stock Market

To measure liquidity in the stock market, you can also use volume. This indicator is even more applicable to the stock market than to the forex market. Also, economic events are also important when defining attractive stocks. Traders flock to the market when financial reports are released. By choosing blue-chip companies, you lower the risk of illiquid stocks. Shares of small companies always provide risks for traders. However, if you still want to trade them, use volume.

If you don't trade CFDs and need to measure the financial liquidity of real shares, you'll have to deal with the company's financial liquidity. It reflects the ability of the company to meet its financial obligations. The current ratio, the quick ratio, and the operating cash flow ratio are used to measure a company's liquidity. 

As you can see, forex securities have the highest degree of liquidity. Thus, they provide limited risk for traders in terms of popular assets becoming illiquid. It allows traders to reach potential success faster.

Conclusion

To conclude, every trader and investor should understand how to measure liquidity. This knowledge prevents traders from falling into losing positions as liquidity determines whether the order will be executed quickly and at a reasonable price. If you'd like to find out more about financial markets and instruments, Libertex is a broker that offers CFDs on stocks, currencies, commodities, indices, ETFs and cryptocurrencies. You can trade and learn about all these asset classes with just one account and on one platform.

Please note that trading CFDs with leverage can be risky and can lead to losing all of your invested capital. However, you can gain confidence and practise your trading skills with different assets in a Libertex demo account, which lets you trade major and exotic currencies, oil, stocks and gold CFDs.

It's risk-free because the demo account mirrors real-market conditions but does so in a test environment that doesn't require real funds. You may want to take advantage of the Libertex demo account to test different securities without risking your funds.

FAQ 

Let's recap what liquidity is in answers to several frequently asked questions. 

What Is Liquidity, and Why Is It Important?

Market liquidity reflects the ability to execute trades quickly and at a fair price. It determines whether a trade will be successfully executed or not.

What Is Financial Liquidity?

Financial liquidity reflects the ability to convert an asset into cash. 

What Does Liquidity Mean in Trading?

Liquidity determines whether your placed order can be executed at the desired price and speed and with a tight spread.

What Is a High-Liquid Stock?

When choosing a high-liquid stock, you can be sure that you'll find buyers/sellers for it without delays and risks for the established price.

Is High Liquidity Good?

High liquidity means that your order will most likely be executed quickly and at your desired price. High-liquid assets are the most popular among traders, while illiquid securities tend to be unpopular.

What Happens When Liquidity Increases?

When an asset's liquidity rises, it means that more market participants are interested in it.

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