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The term ‘liquidity’ is constantly being tossed around in the finance industry, but what exactly does it mean? Today, we will explore the concept of liquidity, its importance in trading and investing, and some of the factors that can influence market liquidity.
Let’s dive into the world of liquidity and explore its significance in the financial ecosystem.
Key Points
- Liquidity in financial markets refers to the ease with which assets can be bought or sold without causing significant price changes; stocks are an example of liquid assets due to their ability to be quickly traded, whereas bonds are less liquid due to longer holding periods.
- Market liquidity ensures efficient trading, characterised by rapid order execution, reduced transaction costs, minimal price impact from large trades, and improved accuracy of asset pricing reflecting collective market knowledge.
- In trading Contracts for Difference (CFDs), liquidity is essential as it affects the speed of execution, pricing accuracy, and the tightness of spreads, all contributing to the overall trading experience and potential success.
What is Liquidity?
Liquidity can be considered at both the asset level (how easily an individual asset can be bought or sold) and the market level (how easily participants can trade within the entire market).
Asset liquidity refers to the ease with which an asset can be bought or sold in the market without significantly affecting its price. A highly liquid asset can be quickly converted to cash with minimal price impact, while an illiquid asset may require more time and effort to sell or may need to be sold at a discount to its fair market value [1].
A typical example of a liquid asset class would be stocks that can be traded and sold, while an asset like bonds is less liquid given that they come with holding periods.
What Is Market Liquidity?
Market liquidity refers to the ability of a market to facilitate the buying and selling of assets with ease and without causing significant price fluctuations. A market is considered highly liquid when there is a large volume of trading activity, allowing participants to execute transactions quickly and easily at stable prices [2].
Here are some advantages when trading highly liquid markets [3]:
- Faster execution: In liquid markets, orders are more likely to be filled quickly, which is particularly important for traders who need to react to market movements rapidly.
- Lower transaction costs: With tight bid-ask spreads, the cost of trading is reduced, making it more attractive for participants to enter and exit positions.
- Less price impact: The ability to trade large volumes without causing significant price fluctuations reduces the risk of price manipulation and increases market efficiency.
- Improved price discovery: High liquidity enables more accurate pricing, as it reflects the combined knowledge and expectations of a larger number of market participants.
Examples of Liquid and Illiquid Markets
The foreign exchange market is an excellent example to showcase a highly liquid market. The daily traded volume for forex market is in the trillions, and major currency pairs, such as EURUSD, have high liquidity and tight bid-ask spreads [4].
A close runner up to the forex markets would be the stock market. Major stock exchanges are considered highly liquid markets, such as the New York Stock Exchange (NYSE), or the NASDAQ. The shares of such large-cap companies can be easily bought and sold without significant impact on prices [5].
On the other end of the spectrum, illiquid markets can include the real estate market as the buying and selling of property can be a lengthy and time-consuming process. From property appraisals, to inspections, negotiations, and even financing, the whole process may take weeks to months [6].
Lastly, another example of illiquid markets is the penny stock market. Penny stocks often have lower trading volume and fewer market participants, resulting in higher bid-ask prices and lesser liquidity.
Does Liquidity Matter When Trading CFDs?
Yes, it does, CFD’s are still impacted by the liquidity of the underlying market.
High liquidity in CFD trading allows for higher price accuracy, execution speed, tighter spreads, and reduced volatility. Here at Vantage when you open a Vantage PRO ECN Account, traders can have access to institutional grade liquidity from the world’s leading providers at their fingertips.
Interested to access deep liquidity and true ECN institutional spreads? Open a Live PRO ECN account here.
Conclusion
By knowing what liquidity is and its implications, traders and investors alike can execute more informed decisions when selecting various asset classes.
As the global economy and financial markets continue to evolve, market liquidity will remain a cornerstone of well-functioning and vibrant markets, fostering growth and opportunities for all market participants.Looking to take a ‘dip’ into highly liquid markets? See what markets Vantage offers here or sign up for a demo account here.
References
- “How a liquidity asset can help your cash flow at short notice – Agicap” https://agicap.com/en/article/liquidity-asset/ Accessed 20 Mar 2023
- “Understanding Liquidity and How to Measure It – Investopedia” https://www.investopedia.com/terms/l/liquidity.asp Accessed 20 Mar 2023
- “Liquid Market: Definition, Benefits in Trading, and Examples – Investopedia” https://www.investopedia.com/terms/l/liquidmarket.asp Accessed 20 Mar 2023
- “Liquid market definition – Forex.com” https://www.forex.com/en-uk/glossary/liquid-market/ Accessed 20 Mar 2023
- “What Investments Are Considered Liquid Assets? – Investopedia” https://www.investopedia.com/ask/answers/032715/what-items-are-considered-liquid-assets.asp Accessed 20 Mar 2023
- “Illiquid – Corporate Finance Institute” https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/illiquid/ Accessed 20 Mar 2023
