What is liquidity in stocks? - Initial Return (2024)

Liquidity is a fundamental concept in finance and trading. But, what is liquidity in stocks in particular and financial markets in general? A liquid stock can be traded easily in relatively large volumes without affecting its price in the market. In contrast, illiquid stocks are traded thinly, such that it may be difficult to find buyers/sellers who are willing to trade large quantities at quoted prices.

Let’s expand on the concept of liquidity further. When we discussed the limit order book in a previous lesson, we paid special attention to two concepts: bid-ask spread and order book depth. In general, a liquid stock would have a low bid-ask spread and a large volume of limit orders waiting to be executed in the vicinity of the bid-ask spread, implying a deep order book. A low bid-ask spread reduces round-trip transaction costs, whereas depth near the bid-ask spread ensures that large market orders can be absorbed with minimal price impact.

To give a specific example, consider the limit order books shown in Figure 1. Stock A is represented by gray bars whereas stock B is represented by the sum of gray bars and blue bars. Stock B is more liquid than stock A for two reasons:

  1. It has a tighter bid-ask spread ($9.16-$9.17 for B vs $9.15-$9.18 for A).
  2. It has larger quantities of shares available for trade at each price level.
What is liquidity in stocks? - Initial Return (1)

The differences between liquid stocks and illiquid stocks are summarized in Table 1. Note that these differences apply to any asset class, and not just stocks. In the remaining part of this lesson, we delve deeper into the dimensions of liquidity.

CharacteristicsLiquid stocksIlliquid stocks
Number of buyers/sellersHighLow
Trading volumeHighLow
Bid-ask spreadTightWide
Price impact of market ordersSmallBig
Price recovery from random shocksFastSlow

Dimensions of liquidity

In a seminal paper (full reference here), American economist Pete Kyle labels market liquidity as a “slippery and elusive concept” and presents three dimensions of liquidity:

  • Tightness
  • Depth
  • Resiliency

These dimensions are illustrated in Figure 2 below. We’ll now discuss them one by one.

What is liquidity in stocks? - Initial Return (2)

Tightness

Tightness is related to the bid-ask spread, which is a cost of trading for investors and a source of revenue for market makers (see our lesson on bid prices versus ask prices for further details).

In general, a market can be called liquid in terms of its tightness if bid-ask spreads are low in that market. This is indeed the case for competitive stock markets such as the NYSE, NASDAQ, London Stock Exchange, etc. The bid-ask spread captures the round-trip transaction cost we discussed earlier. More specifically, if you buy some shares at the market price and sell them back immediately, the cost you incur is equal to the size of the bid-ask spread.

We would expect stocks with large trading volumes to score better in terms of tightness compared to, for example, penny stocks with thin trading.

Depth

A stock is also regarded as liquid if large market orders can be fulfilled without a significant impact on the market price. This is the depth dimension of stock liquidity and is related to the concept of price impact.

To give a practical example, suppose stocks A and B have the same lowest ask price of $10. Let’s also assume there are 10,000 shares available at this price for stock A and 1,000 shares for stock B.

This means that a market buy order of, say, 5,000 A shares could be fulfilled at $10 as there is a sufficient quantity of A shares available at this price. However, a market buy order of 5,000 B shares could only be partially filled at $10. In this case, the investor would get 1,000 B shares at $10 and would have to pay more than $10 for the remaining 4,000 B shares. And, after the execution of these market orders, the lowest ask would remain at $10 for stock A but would be higher for stock B.

In general, the larger the market orders that can be fulfilled with little impact on the market price, the more liquid the stock is.

Resiliency

Resiliency can be defined as the speed with which the price of a stock would recover from a random shock, which is not value-relevant. Liquid stocks are resilient in the sense that the speed of recovery is fast.

To explain the concept, let us assume the highest bid for a stock is $10 at the moment. Let’s also imagine, a few institutional investors submit a series of large market sell orders that pull the highest bid down to $9 after execution.

To the extent that these orders were submitted to satisfy the liquidity needs of these institutional investors, they carry no information about a change in the value of the stock. In other words, these investors did not sell their shares because of any negative news or information about the firm.

In this case, we can expect the price to revert to $10 as the price drop was due to an uninformative shock. And, the more resilient the stock is, the quicker the price would bounce back to $10.

Summary

What is liquidity in stocks? This’s the question we address in this lesson. We’ve explained that liquidity is all about the ability to trade a stock (or any other security) in large quantities without a long wait and/or significant impact on its price. We’ve also discussed tightness, depth, and resiliency as the key dimensions of liquidity.

Further reading:

Kyle (1985), ‘Continuous Auctions and Insider Trading‘, Econometrica, Vol. 53, No. 6, pp. 1315-1335.

What is next?

This lesson is part of our course on the fundamentals of trading.

  • Next lesson: We will be focusing on the psychology of trading.
  • Previous lesson: We discussed what is meant by an arbitrage opportunity in financial markets.

If you have enjoyed reading this post, consider sharing it with your friends and colleagues on social media platforms. If you have any questions or suggestions for us (including spotted errors), let us know by leaving a comment here.

What is liquidity in stocks? - Initial Return (2024)

FAQs

How do you calculate the liquidity of a stock? ›

They estimate the liquidity measure as the ratio of volume traded multiplied by the closing price divided by the price range from high to low, for the whole trading day, on a logarithmic scale. The authors use the price at the end of the trading period because it is the most accurate valuation of the stock at the time.

What answer best describes liquidity? ›

Answer and Explanation:

A firm's liquidity indicates the ability of a company in meeting its current obligations using its liquid assets.

What is liquidity quizlet? ›

What is liquidity? How quickly and easily an asset can be converted into cash.

What is the liquidity for stocks? ›

A stock's liquidity generally refers to how rapidly shares of a stock can be bought or sold without substantially impacting the stock price.

How do I calculate my liquidity? ›

Types of Liquidity Ratios
  1. Current Ratio = Current Assets / Current Liabilities.
  2. Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities.
  3. Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.

How do you find good liquidity in stocks? ›

Check out some of the online financial services, such as Yahoo Finance or Google Finance. These sites will regularly list highly liquid and highly volatile stocks during the day. You can also get this information from most online broker sites in real-time.

What is liquidity for dummies? ›

Liquidity is the ease of converting an asset or security into cash, with cash itself being the most liquid asset of all. Other liquid assets include stocks, bonds, and other exchange-traded securities.

How to identify liquidity? ›

Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market. Liquidity is considered “high” when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller.

What is liquidity answer in one sentence? ›

Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities.

What is liquidity in short-term? ›

Liquidity and Short-Term Assets

Liquidity refers to a company's ability to collect enough short-term assets to pay short-term liabilities as they come due. A business must be able to sell a product or service and collect cash fast enough to finance company operations.

Which statement best defines liquidity? ›

Which of the following best defines liquidity? It is the ease with which an asset is converted to the medium of exchange.

What statement shows liquidity? ›

For a corporation with a published balance sheet, there are various ratios used to calculate a measure of liquidity. These include the following: The current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities.

What is the simple definition of liquidity? ›

Liquidity refers to how quickly and easily a financial asset or security can be converted into cash without losing significant value. In other words, how long it takes to sell. Liquidity is important because it shows how flexible a company is in meeting its financial obligations and unexpected costs.

What does liquidity tell us? ›

Liquidity refers to how easily or efficiently cash can be obtained to pay bills and other short-term obligations. Assets that can be readily sold, like stocks and bonds, are also considered to be liquid (although cash is, of course, the most liquid asset of all).

What is liquidity in stock options? ›

There are generally two ways in which to determine liquidity for an option. First is the daily volume, or how many times it was traded that day. The higher the volume, the more liquid it is, while a lower volume will mean a lower level of liquidity. The second way to determine liquidity is through open interest.

What is the formula for current liquidity? ›

To calculate this ratio, divide a company's total cash and cash equivalents by its total current liabilities. Here, a higher ratio indicates that the company has enough liquid assets to cover all its short-term obligations without selling any other assets. A cash ratio of 1:1 or greater is generally considered healthy.

What is the liquidity ratio of a stock? ›

Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.

What is the formula for liquidity indicator? ›

Overall liquidity ratio

The data necessary to calculate this index is found in the balance of your company's patrimony. Calculating it is simple: (current assets + long-term assets) / (current liabilities + long-term liabilities).

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