Liquidity
SUMMARY
Liquidity refers to the ease with which an asset can be bought or sold in a market without causing a significant change in its price. Highly liquid markets enable fast execution with minimal price impact, while illiquid markets have wider spreads and higher transaction costs.
Measuring liquidity
Traders and market participants assess liquidity through several key metrics:
- Bid-ask spread - The difference between the best buy and sell prices. Tighter spreads indicate higher liquidity.
- Market depth - The volume of orders available at each price level in the order book.
- Trading volume - The total amount traded over a given period.
- Price impact - How much a large order moves the market price.
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Liquidity in practice
High liquidity (e.g., S&P 500 stocks, EUR/USD):
- Tight bid-ask spreads
- Large orders execute quickly
- Minimal slippage
Low liquidity (e.g., small-cap stocks, exotic derivatives):
- Wide bid-ask spreads
- Large orders move the price significantly
- Higher transaction costs
Why liquidity matters
Liquidity affects nearly every aspect of trading:
- Execution quality - Liquid markets allow better fills with less slippage
- Risk management - Illiquid positions are harder to exit during stress
- Pricing - Liquidity risk is priced into asset valuations
- Market stability - Liquidity can evaporate quickly during crises