Liquidity is a fundamental concept in finance and trading. But, what is liquidity in stocks in particular and financial markets in general? What is the definition of liquidity risk? In this post, we address these questions by offering a definition of liquidity in economics and finance.
- Definition of liquidity in economics and finance
- What is liquidity in stocks? A more detailed analysis
- Definition of liquidity risk
Definition of liquidity in economics and finance
In economics and finance, we can define an asset’s liquidity as the ease with which that asset can be traded close to its market value. To elaborate, let’s compare stocks and real estate (two major asset classes) in terms of liquidity.
Let’s imagine that you own 100 shares of Microsoft stock, which trade on NASDAQ. Let’s also suppose that the current market value of these shares is $380. Because there are many investors standing ready to trade Microsoft shares at any point in time, you would have no problem selling your shares at a price very close to $380 if you submitted a market order (if you are unfamiliar with the concept of a market order, check out our post on the difference between market orders and limit orders).
Moreover, if you changed your mind and wanted to buy back Microsoft shares immediately, you could do that easily by placing a market buy order. Importantly, the price you pay to buy back Microsoft shares would still be very close to $380, meaning that the round-trip transaction cost of selling shares first and buying them back immediately would be small. This all points to the high liquidy of Microsoft shares such that it is easy to buy and sell these shares close to their market values.
Now, let’s suppose that you would like to sell your house and invite a real estate agent to value your property. You follow the agent’s advice and put your house on the market for $300,000. Unfortunately, unlike your Microsoft shares, you would not be able to sell your house immediately! It may take months before you can find a suitable buyer. In fact, you may be forced to reduce the advertised price below $300,000, the level the real estate agent believes to be the market value, to attract more buyers. For example, you may end up selling your house for $280,000 after four months.
And, if you change your mind and decide to buy back your house (or buy a similar one in the same neighborhood), it is very unlikely that you would achieve that quickly either. In fact, there may not be any similar houses in the area up for sale, meaning that you might end up waiting a long time.
It becomes clear that stocks (especially those trading in well-developed stock markets such as those in the US, UK, etc.) are more liquid assets than real estate. It is much easier to buy/sell stocks than real estate in a short space of time at a price close to their market values, which is the definition of liquidity in economics and finance.
What is liquidity in stocks? A deeper look
Now that we have offered a broad definition of liquidity in economics and finance, we can move on to discussing liquidity within the context of stock markets in more detail. In particular, based on Kyle’s (1985) seminal paper (see the full reference at the bottom of this page), we will focus on the following dimensions of liquidity:
Tightness is related to the bid-ask spread involved when trading stocks (we have a separate post on bid prices and ask prices in case you are unsure about these terms). Briefly, the bid-ask spread is a cost of trading for investors and a source of revenue for market makers.
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. For stocks with large trading volumes like Microsoft, Facebook, etc., bid-ask spreads are small. So, the round-trip costs are small as well, testifying to the high liquidity of these stocks.
A stock is also regarded as liquid if large market orders can be fulfilled at a (weighted-average) price close to the market price. This is the depth dimension of stock liquidity and is related to the concept of price slippage.
To give a practical example, suppose stocks A and B have the same market 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 5,000 A shares could be fulfilled at the market price of $10 as there are 10,000 A shares available at that price. However, a market buy order of 5,000 B shares could only be partially filled at the market price of $10 (only 1,000 B shares are available at that price). 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.
In general, the larger the market orders that can be fulfilled with a small price slippage, the more liquid a stock becomes.
Finally, let’s again consider a case where a stock’s market price is $10. This time let’s assume the price goes down to $9 because of large orders submitted by a bunch of institutional investors who had liquidity needs. 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 liquid a stock, the faster its price would bounce back to $10. This is the resiliency dimension of liquidity, which captures the speed with which prices recover from random shocks.
We summarize our discussion of liquidity in stocks by referring to Figure 1. On the vertical axis, we have the stock price levels. On the horizontal axis, we have the quantity available for trade at particular price levels.
Tightness captures the difference between the ask price and bid price (bid-ask spread). A smaller tightness implies higher liquidity.
Depth captures the amount of quantity that can be bought/sold before the ask/bid price starts to go up/down. A higher depth implies higher liquidity.
Resiliency is the speed at which the price reverts to its original bid/ask level following an uninformative shock. More resilience means higher liquidity.
Definition of liquidity risk
Liquidity risk can be broadly defined as the risk associated with the inability to trade an asset in the desired quantity over a certain period without having an adverse price impact. So, liquidity risk is all about the risk that a liquid asset suddenly becomes illiquid. While liquid assets can be traded easily in large quantities at or close to their market prices, it is hard to trade illiquid assets quickly unless you are ready to sell them at a deep discount or buy them at a high premium.
We consider stocks to be liquid assets, in general. This is particularly so with large caps with high trading volume. There are times, however, when stock liquidity can berather illusionary. The history is full of examples of when a company’s stock price goes into freefall due to, say, a corporate scandal, lawsuit, etc.
Even worse, during financial crises, the entire stock market could get into a downward spiral. At such times it would be difficult to find buyers for many stocks even at prices much lower than prices that were recently observed. This systematic nature of liquidity risk is particularly worrisome as it implies that there is no shelter during such crises. In fact, there are asset pricing models that explicitly consider liquidity risk as a source of systematic risk. For example, Acharya and Pedersen (2005) adjust the capital asset pricing model to factor in liquidity risk (see the full reference at the end).
In this post, we have addressed a number of questions: What is the definition of liquidity in economics and finance? What is liquidity in stocks? What is liquidity risk? We have explained that most stocks are relatively liquid assets, such that they can be traded easily at prices near their market values. We have discussed the three key dimensions of liquidity: tightness, depth, and resiliency. We have also highlighted liquidity risk as an important type of financial risk and have discussed the issues that emerge when liquidity risk is systematic.
Further reading on liquidity
Acharya and Pedersen (2005), ‘Asset pricing with liquidity risk‘, Journal of Financial Economics, Vol. 77, No. 2, pp. 375-410.
Kyle (1985), ‘Continuous Auctions and Insider Trading‘, Econometrica, Vol. 53, No. 6, pp. 1315-1335.
What is next?
This post is part of the series on trading basics. In the previous post, we explained how order books work and discusses concepts such as order book depth and slippage. Next, we will be discussing the role of emotions in trading and how traders can learn to manage their emotions.
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 below.