How Liquidity Risk Affects Your Trades
When trading or investing, people meet with different kinds of risks. Risk of loss, risk of missed opportunities, liquidity risk, etc. If everyone fears missing the perfect entry point and losing their money, they are not thinking about the liquidity risk. The liquidity risk is barely discussed, although it’s a crucial point of successful trading.
What Is Liquidity and Liquidity Risk?
Liquidity stands for the ability of the company or an individual to convert something they own into cash immediately and at a desirable price. If talking about liquidity in trading, we understand that we don’t own a specific asset. Thus, it is an opportunity to buy or sell an asset fast and without losses.
Liquidity risk is a lack of the ability to buy or sell a security fast and at a desirable price.
Liquidity risk is a situation when there are not enough buyers or sellers in the market who are ready to buy or sell an asset at the price you want. Such an event leads to huge bid-ask spreads and high price fluctuations. The risk occurs because of the marker inefficiency or asset illiquidity.
Liquidity Risk: Types
There are two major types of liquidity risk:
- Market liquidity relates to an event when you can’t buy or sell an asset at the price you want. As a result, you either have to wait for longer or buy/sell your asset at the unsatisfying price.
- Funding liquidity stands for the lack of a company’s ability to pay for its obligations. It happens due to the financial crisis or the company’s ineffective administration, which leads to a funds reduction.
Factors of Liquidity Risk
When you read the news or market analysis, you may hear something like the market suffers from low liquidity. But why are some markets liquid, and others are not? Let’s consider factors that affect the security’s liquidity.
- The number of market traders. It’s the main factor that determines the liquidity in the market. The more traders who are willing to trade the asset you want to buy or sell, the more chances your desired price will be fulfilled.
- Size and frequency of trades. Some of the assets are traded more frequently than others. For example, if we consider the forex market, the EUR/USD pair is more popular than the MXN/USD one.
- Time of trade completion. A liquid asset can be exchanged to cash immediately after the order is placed. However, if a trader hurries to buy or sell an asset, it will raise the liquidity risk. If a trader has time to wait until the desired price is met, the risk drops.
- Substitution. If the position is unique, the risk moves up. However, if it can be replaced with another asset, the risk will decline.
- Type of asset. Assets have a different degree of liquidity. For example, the stock market is more liquid than the real estate market.
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