What is market liquidity?

What is market liquidity?

Before delving into the topic of liquidity in stocks, it is essential to establish an understanding of the importance of markets.

Why is it important to have a market?

Why do you believe that having a market is crucial, both from the standpoint of companies and investors?

As an investor, it is crucial to have the ability to sell your stocks promptly whenever you choose to do so.

For instance, consider this scenario:

If I were to inform you about a house that offers a great deal, you might be interested in purchasing it. However, now envision a situation where I mention that once you buy this house, there is no market available to sell it. this implies that once you make the purchase, you are indefinitely committed to it. In such a case, even if it’s an advantageous deal, you may reconsider your decision due to the lack of an option to sell the property.

So having a market is essential because it provides you with the opportunity to sell assets or products that you no longer wish to hold.

That is precisely why having a market is crucial for investors. It is important to ensure that there is a market available for whatever asset or product you are purchasing so that when you are ready to divest, you can easily dispose of it without encountering any difficulties.

Numerous products lack a market, making them considerably more challenging to sell since there is a limited demand for them. Consequently, potential buyers are reluctant to acquire these products due to the fear of being unable to resell them and convert them into cash.

Products that have an established market tend to be valued more fairly compared to those without a market.

From a company’s perspective, having a market for their stock allows them to assign a higher valuation to their shares compared to when no market exists. This is because without a market, there is a lack of demand from potential buyers, resulting in decreased interest and willingness to purchase the stock.

Having a market is of utmost importance for both investors and companies.

This leads us to the concepts of liquidity.

What is market liquidity?

Liquidity refers to the degree of ease and speed with which an asset or security can be bought or sold in the market without causing significant price movements.

It is a measure of how quickly and efficiently an asset can be converted into cash without impacting its market value.

If you can sell something rapidly without causing any significant impact on its price, it is considered to be a liquid asset.

Two distinct types of liquidity exist market liquidity and asset liquidity. Market liquidity is comparing different markets to each other.

To illustrate, let’s compare the liquidity of the real estate market and the stock market.

The real estate market is generally considered more illiquid compared to the stock market.

When selling a house quickly in the real estate market, there is a higher likelihood of affecting the sale price negatively. Buyers may perceive the urgency and negotiate for a lower price.

In contrast, when swiftly selling stocks in the stock market, even if done quickly, the impact on the market price is typically minimal.

The liquidity of the stock market allows for a more efficient and stable pricing environment, with less disruption caused by quick transactions.

Within each market, there are varying levels of asset liquidity.

For instance, in the real estate market, a downtown condo is considered more liquid. Even if you were to sell multiple condos on the same block relatively quickly, you would still expect to sell them within the expected price range.

However, if you own several industrial complexes in the suburbs and wish to sell them quickly, you may encounter challenges in obtaining a favorable price. The market for such properties is smaller compared to downtown condos, resulting in a greater impact on prices when attempting to liquidate them rapidly.

So, within each market, there are assets that possess varying degrees of liquidity compared to one another.

The same concept extends to financial markets, where different financial instruments can vary in terms of their liquidity.

Let’s look at liquidity in stocks.

There are highly liquid stocks like AAPL and MSFT, where you can sell a substantial amount of shares, even in the millions of dollars, and still receive a price close to the prevailing market rate.

However, there are also less liquid stocks that trade infrequently and are relatively unknown. When selling a smaller amount, say a hundred thousand dollars worth of such stocks, the market for those stocks may become highly volatile, resulting in a significant decline in their value.

It is crucial to exercise caution when dealing with these less liquid stocks.

The same principle holds true for all financial markets, including forex and crypto.

How do you know your stock is liquid or illiquid?

A simple approach is to examine the average trading volume of a stock.

If a stock has an average volume of 10 million, it means that, on an average day, approximately 10 million shares of that stock are traded. Conversely, if a stock has an average volume of 100 thousand shares, it suggests that around 100 thousand shares are traded per day, on average.

Look at MSFT’s average volume

The average volume of MSFT stands at 29.88 million, signifying that it trades nearly 30 million shares per day, which is an impressive volume. making it liquid stock.

Now look at AAME’s average volume

On average, this particular stock trades at a significantly lower volume of only about 4 thousand shares. With such low trading activity, even selling a couple of hundred shares could potentially impact the price. so this stock is considered illiquid.

Liquidity also facilitates price discovery, as a liquid market with numerous buyers and sellers helps determine fair market prices.

Overall, liquidity plays a crucial role in financial markets, benefiting both investors and companies by providing efficiency, flexibility, and transparency in buying and selling assets.