Liquidity: Find a Reliable Asset
Liquidity is a common term in the financial world. Market liquidity determines the speed of market operations and an investor's ability to earn money on a specific asset. Financial liquidity allows investors to define securities that can be easily converted to cash. Thus, if you have just started your trading path, please slow down for a while and read this tutorial.
What Is Liquidity?
Let's start by unraveling liquidity meaning. There are two types of liquidity. These are market liquidity and financial liquidity.
Market liquidity determines the degree to which a security can be purchased or sold fast at an acceptable price. Simply stated, liquidity determines how fast sellers can sell a specific asset, and buyers can buy the same asset.
Financial liquidity determines how fast and easy the asset can be converted into cash. This type of liquidity is important for investors in real stocks and bonds if we talk about financial markets. It’s vital to understand how fast you can convert owned securities into money. If you concentrate on the Forex market, financial liquidity is less important for you.
Market liquidity determines the degree to which a security can be purchased or sold fast at an acceptable price. Financial liquidity determines how fast and easy the asset can be converted into cash.
Although the definition of financial liquidity is quite simple, we want to share a life example. Imagine you want to buy a washing machine. If you have cash, you can quickly go to the shop and get your new washing machine. Money is the most liquid security. If you don't have money but have a credit card, you are more likely to buy the washing machine without any problems as shops accept credit cards.
But what if you don't have cash or credit cards but own stocks. Then you should do some operations on the stock market. Only after that will you get cash to buy the washing machine. Although equity is a liquid asset, it still takes time to exchange it for money.
Okay, now you don't have cash, cards, or stocks, but you still need that washing machine. Then you need to sell something. To do that, you need to find a buyer who will accept your price. It will take even more time to exchange this security for cash. Thus, the last asset is the least liquid.
Liquidity: Why Is It Important?
Any trader or investor needs to understand how liquid the market is.
Market liquidity affects many aspects of the trade.
- The price at which your order can be executed. Imagine you want to sell the USD/TRY pair at 7.65. However, there are not enough buyers who will accept this rate. Thus, your trade won't be executed at the willing price.
- The time of trade execution. If there is no seller/buyer on the counter side of the trade, there is no opportunity to execute the order. Thus, an investor should wait until market participants appear.
- Spread. The less liquid the market is, the higher spread there will be.
Financial liquidity allows investors to understand how fast they can convert securities into cash. It’s a key point if you want to purchase stocks or bonds. Knowing their degree of liquidity, you can be sure you will get money as soon as you need it.
Market Liquidity vs. Volatility
Liquidity is interconnected with volatility. Both terms relate to market risk. High volatility and low liquidity of assets provide additional risks for traders.
Liquidity is interconnected with volatility.
In times of increased volatility, it's vital for a trader to choose a highly liquid market. Imagine you want to sell an asset because the market fluctuates significantly. However, the market is illiquid, and there are no buyers who can satisfy your order. You can't close your trade, and the risk of losses increases significantly.
The Most Liquid Markets
Liquidity occurs in different financial markets. However, the degree of liquidity doesn't directly depend on the market but rather on traded securities. Still, we can highlight the most liquid markets. Let's consider what degree of liquidity you can expect.
It's no secret that Forex is one of the most popular financial markets.
First, cash is the most liquid asset as cash is used as a means of payment everywhere. Second, it's one of the most popular and accessible markets. Third, governments, banks, big corporations, and investment houses are significant participants in this market.
Still, you should understand that Forex is represented by different currencies. Major currency pairs provide high liquidity. At the same time, exotic currencies have low liquidity.
Stocks are widely traded assets. This market is more complicated and less accessible than the Forex market. Still, investors all over the world enter this market in order to have the option to increase their income.
The same applies to the Forex market, there are highly liquid and less liquid stocks. Also, you should understand that the stock market securities are measured by financial and market liquidity.
Another market we can call high liquid is the commodity market. Previously, the commodity market was considered less liquid. Since CFDs, ETFs, and futures were developed, the market became more popular among traders, which added to its market liquidity.
Different commodities have different degrees of liquidity. In the next paragraphs, we will explain what degree of liquidity they have.
The bond market provides high financial liquidity. Yet, you should keep in mind the reliability of companies whose bonds you want to purchase. Companies from stable industries and with a big cap are supposed to provide high liquidity.
Financial Instruments: High Market Liquidity
As we mentioned above, the liquidity of assets differs. Here, we will talk about market liquidity.
Major currencies represent the stable economies of developed countries. These currencies are used in world financial operations. That's why they provide high liquidity. If you are a beginner trader, choose major currencies to avoid illiquid trades.
Most of the traders prefer oil despite its high volatility. Oil prices are hardly predictable. Still, oil is one of the most usable assets. Moreover, there are different options to trade.
Gold is the most liquid asset among metals. As you might hear, gold is used as a safe-haven asset. Thus, many traders use it to hedge risks.
The most liquid shares are those of blue-chip companies. Such shares are traded at world stock exchanges. There is a theory that companies with a large market cap are more stable, and their stocks are more reliable for investors. They will always attract investors; thus, the liquidity of assets will never go low.
Financial Instruments: Low Market Liquidity
Let's consider the securities that may create problems for you, especially if you are a newbie trader.
Exotic currencies are the least liquid assets on Forex. The low liquidity is caused by the fact that investors avoid these securities. It's difficult to predict their direction. Usually, the direction of exotic currencies depends not on economic events listed in the economic calendar but on political events and global market sentiment. Thus, a high degree of unpredictability pushes investors away.
Moreover, exotic currencies present emerging markets. The unstable economic and political situation in such countries doesn't allow investors to trade these assets.
Although the stock market is one of the most liquid, small-cap shares are less liquid than big companies. If you don't have enough funds for blue-chip corporations' stocks, you can try trading shares of smaller companies. Still, you should understand that there is the risk of a smaller number of market participants.
Assets: High Financial Liquidity
Financial liquidity differs from market liquidity. Thus, financial instruments are supposed to differ as well.
Bonds and stocks have high financial liquidity, as they are easily converted to cash. Although you should consider many factors that affect their degree of liquidity, which will be mentioned later, these securities are converted to cash with limited efforts.
Assets: Low Financial Liquidity
If you consider such assets as real estate, art, stamps, buildings, or coins, it’s unlikely you will easily find buyers for them. That’s why their degree of liquidity will be much lower than those of stocks and bonds.
Moreover, if you decide to convert restricted equities, their liquidity is supposed to be low as well.
How to Measure Liquidity
There are two degrees of liquidity. High market liquidity is when there are enough buyers and sellers, and the asset can be easily traded. High financial liquidity is when you can easily convert your asset into cash, so there are always buyers on the market.
Low market liquidity occurs when there are few market participants, and the trade can't be executed. Low financial liquidity means that your asset is rare and is not popular among buyers.
In common words, liquidity can be calculated using the volume of trades or the volume of pending trades placed currently on the market.
We have talked about financial markets in general. Let's consider the most liquid markets and how to measure their liquidity.
To define liquidity in the Forex market, you can apply volumes on the price chart. Volume bars show traders whether the trade is extensive or not.
Also, the liquidity of Forex depends on the assets you trade. For instance, exotic currencies are among such assets. It's hard to predict their direction; they are highly volatile. Thus, traders prefer to avoid such securities.
Also, the liquidity depends on the market you trade. Every trader should know about trading sessions. For example, the Asian session starts at 11 p.m. GMT and ends at 8 a.m. GMT, while the NY session begins at 12 p.m. GMT and ends at 8 p.m. GMT. If you decide to trade Asian assets during the NY session, it's unlikely the market will be highly liquid as major traders won't be there.
Market events are another factor that may provide additional liquidity to the market. In times of significant economic and political events, the number of market participants may increase significantly as fundamental analysis is one option to predict potentially successful trades. For example, NFP release is always a trigger for traders who want to try their luck, experience, and knowledge in the market.
To measure liquidity in the stock market, you can also apply volumes. This indicator is even more applicable for the stock market than for Forex.
Also, economic events will become an important point when defining attractive stocks. In the time of earnings reports, traders come to the market.
Choosing blue-chip companies, you lower the risk of illiquid stocks. Shares of small companies always provide risks for traders. However, if you still want to trade them, you can use volumes.
If you don’t trade CFDs and need to measure the financial liquidity of real shares, you will have to deal with the company's financial liquidity. It reflects the ability of the company to meet its financial obligations. The current ratio, the quick ratio, and the operating cash flow ratio are used to measure the company’s liquidity.
As you can see, Forex securities have the highest degree of liquidity. Thus, they provide a limited risk for traders. It allows traders to reach potential success faster.
To conclude, every trader and investor should understand how to measure liquidity. This knowledge prevents traders from losing positions as the liquidity determines whether the order will be executed fast and at a reasonable price.
However, to be confident when opening trades with different assets, you should practice on a demo account. A Libertex demo account allows you to trade not only major and exotic currencies but oil, stocks, and gold through CFDs. Take advantage of the opportunity to test different securities without risking your funds.
Why to trade with Libertex?
- access to a demo account free of charge
- technical assistance to the operator 5 days a week, 24 hours a day
- leverage up to 1:500 for professional clients
- operate on a platform for any device : Libertex and Metatrader 4 and 5
- no commissions for extractions in Latin America
Let's gather all the knowledge about liquidity in several answers.
What Is Liquidity, and Why Is It Important?
Market liquidity reflects an ability to execute trades fast and at a fair price. It determines whether the trade will be successful or not.
What Is Financial Liquidity?
Financial liquidity reflects an ability to convert an asset into cash.
What Does Liquidity Mean in Trading?
Liquidity determines whether your placed order can be executed at a willing price, fast, and with a tight spread.
What Is a High-Liquid Stock?
When choosing a high-liquid stock, you can be sure that you will find buyers/sellers for it without delays and risks for the established price.
Is High Liquidity Good?
High liquidity confirms your order will be executed fast and at the price you want it to be done. High liquid assets are the most popular, while illiquid securities are unpopular among traders.
What Happens When Liquidity Increases?
When the liquidity of an asset rises, it means that more market participants are interested in it.