Liquidity

Liquidity refers to the degree to which an asset can be quickly bought and sold at stable prices and converted into cash. It indicates how swiftly and at what cost one can sell an asset, whether it is a financial asset like a stock or a tangible asset such as a commercial property.

If an asset has a “true” or fundamental value of $100 and can be instantly converted into $100 in cash or cash equivalents, the market for that asset is considered perfectly liquid. However, such perfectly liquid markets are rarely found in reality.

Liquidity also measures how quickly a buyer can convert cash into a tangible asset. In a perfectly liquid market, a buyer looking to purchase an asset valued at $100 can do so immediately for exactly that amount and receive it right away. It reflects the number of buyers and sellers present and the ease of conducting transactions.

Typically, liquidity is assessed by analyzing the volume of trades or pending trades in the market. High liquidity indicates significant trading activity, with both high supply and demand for an asset, making it easier to find buyers or sellers. Conversely, if there are only a few market participants trading infrequently, liquidity is deemed low, resulting in an illiquid market.

Why is liquidity so important? Market liquidity is crucial for several reasons, primarily because it affects how quickly positions can be opened and closed. A liquid market is generally associated with lower risk, as there is usually someone willing to take the opposite side of a position. This can attract more traders, contributing to favorable market conditions.

In a liquid market, sellers can quickly find buyers without needing to lower the asset's price to make it more appealing. Similarly, buyers do not have to increase their offers to acquire the desired asset. An asset's liquidity is also a significant factor in determining the spread provided by a trading platform or broker. High liquidity means a large number of buy and sell orders exist in the market, increasing the likelihood that the highest price a buyer is willing to pay and the lowest price a seller will accept will converge. In other words, a liquid market results in a tighter bid-offer spread, while an illiquid market leads to a wider spread.

What causes illiquidity? Two frictions contribute to markets being less than perfectly liquid, resulting in illiquidity. The first is an indirect cost, which refers to the time it may take to convert an asset into cash. For instance, one might need to take the asset to a market or wait for a buyer to appear. This waiting time, often called waiting cost or search cost, is a manifestation of illiquidity and detracts from perfect liquidity.

The second friction is a direct cost. One might choose to pay a fee to sell the asset immediately instead of waiting to find someone willing to pay the full $100. This involves paying a dealer to handle the waiting, effectively compensating them for transaction immediacy or liquidity. This cost is known as a transaction cost or liquidity cost, commonly referred to as the “bid-ask spread.” For example, one might sell an asset to a dealer for $99.00, allowing the dealer to find a buyer willing to pay the full price. In this scenario, the dealer provides transaction immediacy for a fee of $1.00. Although the waiting cost is eliminated, this situation does not represent perfect liquidity due to the fee involved.

While the term dealer is commonly used for those providing transaction immediacy (or liquidity) services in financial markets, other terms like principal, financial intermediary, and broker are also applicable. In financial markets, institutions such as investment banks typically act as dealers for investors.

How to use liquidity in trading: When trading in financial markets, it is essential to consider liquidity before opening or closing any position. A lack of liquidity is often linked to increased risk. If market volatility occurs with fewer buyers than sellers, closing a position can become challenging. In such cases, one risks being stuck in a losing position or may need to approach multiple parties at varying prices to fill an order.

The key takeaway is that market liquidity is not static; it is dynamic and constantly fluctuates between high and low liquidity. The current liquidity level depends on various factors, including the number of traders and the time of day. For instance, trading outside regular hours may result in fewer market participants, leading to lower liquidity. An example is the CHF currency pairs during Asian trading hours, which typically exhibit less liquidity compared to European trading hours, resulting in wider spreads.

The forex market is regarded as the most liquid market globally due to the high volume and frequency of trades. In this context, liquidity pertains to a currency pair's ability to be bought and sold without causing significant changes in its exchange rate. A currency pair is considered highly liquid when it can be easily traded, supported by substantial trading activity.

Despite its high liquidity, the forex market does not always exhibit stable pricing. The large number of participants trading major pairs leads to diverse opinions on price, resulting in daily fluctuations, especially during news events. The most liquid pairs in forex include EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD.

In forex trading, liquidity is crucial as it tends to minimize the risk of slippage, ensures faster order execution, and results in tighter bid-offer spreads.