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.
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