Liquidity is an important concept in the financial market. It has two main connotations in a macroeconomic and microeconomic sense. In macro, liquidity is defined as the overall flow of money, which is influenced by a central bank.
On the other hand, in microeconomics, liquidity refers to the available supply of an asset in a certain period.
For example, in forex trading, pairs like the EUR/USD and GBP/USD are popular, meaning that you can buy and sell them easily. There will always be counterparties for these securities.
On the other hand, some currency pairs called exotic like TRY/BRL (Turkish lira vs Brazilian real) or SGD/TRY ( Singapore dollar vs lira) are often thinly traded. Most brokers that provide these pairs see only a handful of activity on a given day.
The same situation happens in the stock market, where some shares like Apple and Microsoft are actively traded compared with other small and unknown firms like Expion360 and Takurn Art.
What is liquidity?
As mentioned above, liquidity refers to the overall volume of an asset that is available in the market. It is an important measure because of its vital impact among traders. In addition to stocks and forex liquidity is also an important part of other assets, like cryptocurrencies and bonds.
In crypto, it is estimated that there are over 21,000 digital currencies in the world today. In these, the most popular ones are Bitcoin, Ethereum, and Ripple.
For these ones, it is relatively easy to trade since there will always be counterparties. On the other hand, there are some coins and tokens that are thinly traded.
How liquidity affects markets
Liquidity has an important role in the market for three main reasons. First, trading low-liquidity assets is usually more expensive than the others. This is more popular in the forex industry, where brokers don’t charge a commission but make money using the bid-ask spread.
For highly-liquid pairs like the EUR/USD and GBP/USD, the cost of transactions is usually negligible. On the other hand, for illiquid pairs like SGD/TRY, the overall cost of transactions is usually relatively high. For American stocks, brokers like Schwab and Robinhood don’t a fee for transactions.
Liquidity also affects the overall time of a trade execution. For high-volume assets, trades are executed at a lightning speed since there is always a counterparty in the other side. On the other hand, for low-volume assets, there is usually a small lag, which could affect profitability.
Related » Understading stock volume
Further, liquidity can have a role in market manipulation. In most periods, it is so difficult to manipulate stocks like Apple and Microsoft which have a daily volume of billions of dollars.
It is easy to manipulate thinly-traded companies worth a few millions of dollars. In some cases, some brokers may cancel some trades because of low liquidity.
Finally, liquidity affects the volatility of an asset. Some thinly traded assets may have a few but large market moves.
How to determine whether a stock is liquid or not
So, how do you determine whether a stock or any other asset is liquid or not? There are three main ways of determining whether a stock is liquid or not.
First, there is the name recognition of a company. For highly popular companies like Apple, Meta Platforms, and Alphabet, liquidity is never a problem.
However, if you identify a small company that is not well-known, chances are that its liquidity will always be lower.
The next thing to check is a company’s relative volume, which is usually provided by most companies, including brokerages like Robinhood and Schwab.
A stock with little relative volume means that it has low liquidity over time. It is relatively easy to identify an asset’s volume in the financial market.
Finally, there is the bid-ask spread of an asset. In stocks, you will likely not see these spreads. But they are popular in forex. If you see a currency pair with thin spreads, it is a sign that they have low liquidity.
Pros of trading low-liquid assets
There are numerous benefits of trading low-liquid assets. First, these assets could be hidden gems since most traders don’t follow them. According to Peter Lynch, it is always possible to make a lot of money in assets that most people avoid.
Second, there is usually no or limited competition in the market. As a result, you can use your experience and expertise to find opportunities in such assets. Finally, you can use these assets’ volatility to gain an edge in the market.
Related » How to Get and Develop a Trading Edge
Ways to trade low-liquid stocks
There are several strategies to use when trading low-liquid stocks. First, always do your research on the asset before you execute a trade. This research could include fundamental or technical analysis.
Second, you should always set a stop-loss and a take-profit when trading these assets because of the volatility risk.
Finally, always trade them when there is an important market-moving event like earnings or economic data.
Risks of low liquidity
As mentioned above, there are several risks for trading low-liquid stocks and other assets. These risks include:
Expensive to trade
As a trader, it is always important to focus on transaction costs. Unlike investors, you likely implement tens of trades per day. And as such, the overall cost of transactions can be high.
Therefore, trading low liquid assets tends to be expensive in most cases because of the wider spreads.
Pump and dump schemes
Thinly-traded stocks and cryptocurrencies are ripe for pump-and-dump schemes. This happens because traders with a limited amount of money can have a major role in stocks.
For example, a trader with a $100k account can easily move a stock of a company with a market cap of about $1 million.
Similarly, a trader and group of traders can manipulate a small crypto. On the other hand, it is relatively difficult to manipulate stocks like Microsoft and Google.
Analysis challenge and exit points
It is always difficult to analyze low-liquid assets like stocks and cryptocurrencies. In most cases, these assets tend to have no major catalysts and news.
Also, in technical analysis, it is almost impossible to incorporate volume into it.
Finally, there are limited exit points especially when the low-liquid asset is also range-bound. It will be difficult to trade such financial assets.
Low-liquid assets are in most cases more than high-liquid ones. In this article, we have explained what liquidity is and how it works in the market. We have also looked at how to trade low liquid stocks and other assets.
External useful resources
- The puzzling decline in financial market liquidity - Bank of International Settlements