Market Liquidity Matters! But How Does It Affect Day Trading?

Liquidity is an important concept in the financial market. Indeed, it can determine how much you pay for an asset and whether you can trade some assets.

In this article, we will look at:

  • what liquidity is
  • why it matters
  • why you should day trade liquid assets

What is liquidity?

Liquidity in the financial market refers to the ease of converting assets into cash in the marketplace. A good way to explain this is when you are conducting your net worth calculation. As part of your assets, you will have items like cash, stocks, home, car, and land.

While the total assets minus liabilities will be your net worth, in reality, the situation is more complex than that.

For one, while it is easy to convert your stocks into cash, other assets like car, home, and land are not easy to convert. In the past, we have seen many people’s property stay in the market for years without finding a buyer. We have also seen many cars lack buyers.

In this case, stocks can be said to be liquid assets while land, property, and cars are illiquid assets.

The same concept applies in the financial market. At times, some assets are simply not easy to sell. For example, some exotic currency pairs or relatively tiny companies usually don’t have enough liquidity.

How liquidity works in trading

To understand how liquidity works, it is important to understand how orders are filled in the market.

Whenever you buy a stock or any other asset, you are basically doing it from another person. This is known as a seller. Therefore, the broker that you use is just an intermediary that matches the two sides.

In most cases, these brokers don’t do the matching themselves. Brokers like Robinhood and Schwab use intermediaries known as market makers. These are the firms that match buyers and sellers in the market.

If you have a direct market access (DMA) as we do here at Day Trade the World (DTTW™), you can select the market maker that you want to use. The most popular market makers are companies like Citadel Securities, ARCA, and Virtu Finance.

The market makers

These market makers will then match your order to another person. Therefore, if a financial asset has a lot of liquidity, it means that your order will be executed instantly. If it does not have liquidity, it means that it will take more time before the order gets filled. More time in this case means a few minutes.

The same approach works when electronic communication networks (ECN) are used. These are different from the ones that use market makers and are typically more popular in extended hours and in the forex market.

Top liquid assets examples

Now that you know what liquidity is, let us look at some of the most liquid financial assets:

  • Popular stocks – In most cases, popular stocks like Apple, Microsoft, Google, and Tesla are usually highly liquid because of the high demand and supply by small and large investors.
  • Popular commodities – In most cases, popular commodities like silver, gold, and crude oil are highly liquid because of the vast amount of them that are traded every day.
  • Common currencies – Some of the most popular currencies like the EUR/USD and GBP/USD are highly liquid.

Top illiquid assets example

The illiquid assets are the opposite of what we have mentioned above. In this case, some unpopular stocks are highly illiquid. For example, very small penny stocks, such as those that are listed in the over-the-counter (OTC) market. Some of these stocks see little or no action per day, which leads to high levels of illiquidity.

Similarly, some exotic currency pairs are highly illiquid. Some are even never provided by most brokers. For example, a currency pair like ZAR/BRL (South African rand vs Brazilian real) is highly illiquid because of the fact that very few trade happens between the two countries.

Meanwhile, some commodities like nickel, orange juice, lean hogs, and live cattle are equally highly illiquid.

Reasons to avoid illiquid assets

To most day traders, it is not recommended to trade them. There are several reasons for this.

First, highly illiquid assets tends to be expensive to trade. This is especially when you are still using a broker that takes a commission per trade. These companies usually take a higher fee because very few traders trade the assets.

Second, highly illiquid assets can be easily manipulated. This is a popular thing especially in penny stocks, where a buyer can pump and dump the asset.

Third, these assets tend to be highly volatile at times. This is partly because of the pump and dump schemes that are popular in them. Furthermore, a trader with $10,000 can move a stock of a company valued at $1 million. They can’t move a stock of a company like Facebook.

»How to Exploit Market Volatility«

Final thoughts

The concept of liquidity is highly important in the financial market because of the risks and costs involved. As we have mentioned, we prefer that you focus your trading journey on companies that are highly liquid like Google and EUR/USD.

Did you find any interesting insights? Let us know, and if you liked it feel free to share the post!

External useful Resources

  • Liquidity: How Understanding Order Flow Determines Trading Success – Bookmap
  • Is there an indicator that measures market liquidity in the stock market? – Quora

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