Liquidity describes the state of the market for an asset in terms of how quickly that asset can be traded without affecting its price.

Markets for assets that can be sold quickly with little or no impact on the price of the asset are said to feature high liquidity, while the opposite features in a market suggest a state of low liquidity.

The concept of liquidity applies to any assets that are traded in a market structure, from cash and securities to real estate and luxury items. Cash is considered to be the most liquid asset, while rare luxury items, such as art and wines, and considered to be the most illiquid assets.

Some assets are never or only rarely traded under a market structure, and the concept of liquidity is considered to not apply to these assets.

Financial Market Liquidity

Liquidity plays two very important roles in contemporary financial markets.

The first role of liquidity in financial markets is obvious: liquidity greases the functioning of securities trading. The more that people are willing to buy, sell and hold securities, the lower the transaction cost and the greater the speed for trading those securities.

Therefore, general market liquidity means that investors can hold an optimal basket of securities for their investing needs without needing to worry about their ability to alter or liquidate their positions as circumstances change. Financial markets with low levels of liquidity, by contrast, are plagued by high trading costs and inefficient investment portfolios.

The second role of liquidity in the financial markets is the result of the growing importance of borrowing and leverage in contemporary trading. Many balance sheets are composed of assets that are nominally owned, but used as collateral for debts.

When general market liquidity dries up, the value of this collateral plummets as lenders become wary of holding illiquid assets as collateral. This drop in the value of collateral in illiquid markets then diminishes the value of balance sheets across the market, which in turn drives a demand for more illiquid collateral to meet the growing shortfall in value.

This is why financial crises can quickly spiral into dangerous contagion, as market actors become wary of providing the enormous amount of every day lending that fuels contemporary financial markets.

When liquidity in general starts to dry up, the contagion effect quickly spreads and the markets freeze up with inaction. Occasionally governments and central banks will intervene in the markets to provide liquidity to offset this dangerous self-reinforcing cycle of low liquidity and falling asset prices.

Liquidity and Trading

Liquidity is very important to day traders, especially those day traders who profit from making many trades, each for a small profit.

A lack of liquidity for a traded security can mean the difference between reaching a profit target and booking a loss on an otherwise perfect trade. Traders generally look to the daily or hourly volume traded for a security to gauge its liquidity for the targeted time frame for trade execution.

The total volume of securities traded and the order size for trade execution should both be considered relative to the average volume traded at that time.

Day traders will generally have little liquidity problems when executing trades for popular equities, currencies, bonds or commodities. However, there are many more exotic and obscure securities that face chronic low liquidity, where even small order sizes will move the price of the market, and traders may watch positions turn unprofitable while they wait for their orders to clear.

Final Thoughts

Liquidity is a very important financial concept for traders to understand, both in its direct effects on trade execution and the larger roles that it plays in the stability of contemporary financial markets.

The contagion that accompanies periods of generally low liquidity in the financial markets can offer excellent trading opportunities alongside the potential for significant losses as asset prices in general drop.

However, day traders generally tend to avoid securities that feature low levels of liquidity, as most day trading strategies are based on the ability to quickly enter and exit positions, often even avoiding losses on failed trades through timely position closing.

It is critical that day traders be mindful of the trading volume for a security before entering a trade, and even track the average volumes for the time of day that they intend to execute their trade.