Liquidity is one of those terms you encounter a lot in the stock market industry.
It may seem difficult at the first look, but it’s not. At the same time, understanding the concept of liquidity is quite essential when you are a day-trader. As a general rule of thumb, you should ask yourself a question: what is liquidity in stocks?
We have had the same doubts when getting started with stock trading, you know.
Therefore, we thought it would be nice to create a quick guide on the liquidity of stocks and how to liquidate the stocks you own. In the end, regardless of how much you know about stock markets, you’d understand what liquidity is.
Let’s start with the most prominent question.
What Is Stock Liquidity?
Stock Liquidity, simply known as Liquidity, refers to how easily you can sell a stock for money without having a noticeable impact on its market price.
You have to keep in mind that Liquidity is a common concept in the world of finance. It refers to the effort you need to sell any asset and get cash in return.
This asset could be equities, real estate, fine art, collectible, partnership units, etc. Many of these asset types have varying levels of liquidity in the market. In our case, which deals with stocks, different stocks may have different liquidity levels.
You can say that a stock is highly liquid if you can buy and sell the stocks without affecting the market price. There are a few factors that determine this. First and foremost, the stock should have a decent demand in the market.
Second, there should be buyers who are ready to purchase the stock at the market price. If the two demands are met, you can accomplish the stock market transaction without hassle, which means the stock is liquid enough.
Let’s take an example.
Suppose you purchased the stock of a particular company by paying $20. There could be two scenarios.
- You can sell the same stock for $20 immediately, meaning there is no delay.
- You cannot sell the stock for the same price due to a lack of buyers who pay the same price.
In the first scenario, we can say that the stock is highly liquid. In the second scenario, however, the stock will be completely illiquid.
Here’s the catch, though. In the stock market, these scenarios are considered so rare. Therefore, almost every time you talk about liquidity, you’ll find a stock’s status in between these two scenarios.
How Important Is Stock Liquidity?
The importance of stock liquidity to you depends on several factors. Most importantly, it relies on the type of trader you are.
As you should know, there are short-term traders and long-term traders in the stock market. These two categories have different outlooks towards stock liquidity.
Short-term traders, which include day-traders and swing traders, should consider the liquidity of stocks as a crucial pointer.
This situation happens because short-term traders have to buy and sell stocks within a short period. Therefore, if the stocks don’t have enough liquidity, trading the stocks during the window may not be possible.
On the other hand, long-term traders can care less about the liquidity of the stocks they handle.
It happens because long-term traders and investors have enough time to wait for the desired bid on a stock. A time window doesn’t bind them, you know. Similarly, investors may be able to wait until the market for the stock turns liquid from illiquid.
Long story short, you should understand the liquidity of a stock if you want to day-trade or swing-trade the stock. It’s not a wise decision to day-trade a relatively illiquid stock.
You may be stuck with stocks that you can’t sell-off. Or you may be able to sell them off, but you’d have to suffer a considerable loss. We are talking about buying a stock at $10 and selling it for $8 or $7.
We hope you understand the essential nature of stock liquidity. Now, we will talk about how you can estimate the liquidity of a stock.
How to Tell If a Stock Is Liquid?
In case you didn’t notice, liquidity isn’t a metric you can find on a stock exchange.
It’s a qualitative measure that provides insight to the trader. Because of this, you have to consider multiple factors to determine the liquidity of a stock. And there are a few ways to go about the entire analysis.
The bid-ask spread refers to the difference between two figures. One, the ask, which is the lowest price a seller would expect for the stock.
The bid is the highest price a buyer is ready to pay for the stock. If a stock has a small bid-ask spread, it will have a decent demand in the market. It also means you can quickly sell off the stocks if you want to.
Therefore, a stock should have a narrow bid-ask spread for it to be liquid. If the spread is far too broad, you’d not be able to sell the stock quickly.
The ease with which you can sell a stock also depends on the trade volume. This figure is vital for a day-trader because it indicates the number of bought and sold stocks throughout a day.
If this figure is high, it means the overall demand for the stock is high among traders. Therefore, you have a better chance of selling the stocks when you want to.
Therefore, a stock should have a high trading volume, at least when the float is high. If it doesn’t, you might have trouble finding buyers who can pay the price you expect.
To Sum Up
Using these two metrics, you can calculate the liquidity of a specific stock. We’d like to repeat that it isn’t a completely quantitative figure. In addition to these metrics, you have to use your understanding of a market to calculate the risks.
For instance, you must pay attention to the float of the share. If the float is too low, there aren’t enough shares to go around in the market, which ultimately leads to a situation where you cannot find the right buyers. It would not happen in the case of popular stocks, though.
What Happens If You Decide to Liquidate A Significant Number of Stocks?
Just to be on the same ground here, liquidating a stock means selling the stock for money. The result of this action may vary quite widely, but here are the two major takeaways.
- If the stock market is liquid enough, you can find buyers who are ready to pay the price you’d ask for a price. Therefore, the transaction goes through fine, and you get the money. In many cases, the stock’s liquidity may be high, and you may end up having some decent profit.
- If the stock market isn’t liquid enough, you may not get enough buyers ready to pay the price. Then, depending on the type of investment you have, you can wait until the desired buyer turns up. However, if you are a short-term trader, you will have to sell the stocks for a lower price.
It may also happen that the liquidity of the stock may have varied over time. In that case, you may find your transaction in-between these two extremes.
By the way, when you liquidate a significant number of stocks, it would impact the overall market price of a stock as well.
That is why you should pay attention to the market metrics before deciding to liquidate a significant amount of stocks. But whether your actions impact the company’s future depends on the total number of stocks and how much of it you own.
Why Are Some Stocks Not Liquid?
As we mentioned earlier, liquidity depends on several factors, such as the ask-bid spread and the total trading volume. Both these factors are highly dependent on how the entity is performing in the market.
For example, if a company’s performance hasn’t been so excellent, people won’t be interested in buying its stock.
On the contrary, during low-performance instances, people may try to liquidate all their stocks, thereby impacting its market price. But the catch is that there may not be enough buyers to compensate for the sellers.
Because of these factors, some stocks stay illiquid. As a day trader, you should stay away from these stocks, as they may put you in trouble. As we mentioned earlier, you may have to sell off the stocks at a lower rate than you expected.
The Bottom Line
We hope this guide did more than clearing your significant doubts about liquidity. As you can see, while a stock’s liquidity isn’t a ready-to-access metric, efforts to estimate the same will help you manage the stocks better.
Therefore, regardless of whether you are a short-term investor or not, you should check the stock’s liquidity levels before buying the stocks. Once you have purchased the stocks, you are bound by the current liquidity of the stocks.