Stocks And Liquidity

It is important that traders and investors consider stock's liquidity when choosing which stocks to buy. Getting fixed with a stock that cannot be sold can turn nightmarish. It is difficult to quantify liquidity as there no exclusive and widely accepted definition of liquidity. In simple terms, liquidity refers to the possibility of any form of asset to be transformed into another form of asset in a short period without losing its value, i.e. change in price.

Based on which a liquid market refers to a place where participants can swiftly carry out large volume transactions without any major price impacts. Liquidity provides safety to the investors and decreases the risk of losses, as market liquidity varies from time to time. Even a listing on the New York Stock Exchange, the American Stock Exchange or even NASDAQ does not guarantee a stock's liquidity.

Certificates of deposits are considered to be less liquid as they have a penalty attached in case of conversion to cash before their maturity date. Savings bonds on the other hand are liquid, as they can be easily sold to a bank. It is the shares of stock, bonds, options and commodities which are considered fairly liquid. They can be sold readily for cash within a few days generally with a small penalty.

Usually it is the large-cap stocks which are the most liquid as they are measured against volume. They provide a higher number of shares available for trading, a high volume of daily trades, and demand from both individual and institutional investors. On the other hand small-cap and microcap stocks provide less number of shares available for trading. The basic rule followed is, higher the average daily volume, higher the liquidity.

Stocks which are less liquid tend to have wider spreads between the ‘bid' (the price offered by a would-be buyer) and the ‘ask' (the selling price) as compaired to liquid stocks which have narrower spreads.

A higher level of illiquidity directly leads to a higher risk on investments where investors face the possibility of higher losses. On the other hand, it also provides for higher gains, when compared to more developed and liquid markets due to price volatility.

Another important aspect of liquidity is to ensure the financial position is based on basis of cash reserve. It is the cash in reserve which provides money for contingency as well as opportunities. Therefore, as an investor, it is important to streamline cash reserve before undertaking risky investments when money is the need of the hour.

Tracking the average dollar volume is regarded as a better option then analyzing and monitoring the average daily volume. As large volume point on one or two days can twist the average trading volume. From the novice traders point of view concentrating on the dollar turned on an average daily day is more useful then the volume of stocks traded.

Traders use various techniques to measures liquidity, for example, one dimensional, volume related, time related, spread related. However, due to complexity and multi-dimensionality of liquidity, different measures provide different conclusions.