What Is Liquidity in Stocks? How to Measure It

Investing in the stock market demands a keen eye for profitable opportunities so traders know when to enter and exit positions swiftly. Whether buying or selling, the ease with which investors can execute these moves often hinges on a key concept: liquidity. 

In this guide, we’ll review what liquidity is in stocks, why it’s important, and how to effectively measure it. We’ll also discuss a few examples of high-liquidity stocks.

What is liquidity in stocks?

Liquidity’s meaning can change depending on which area of finance you look at. However, its most common usage is in the context of stocks, which refers to the ease with which shares can be bought or sold. 

Think of it this way: You have a stock you want to sell. High liquidity implies you can quickly find a buyer willing to purchase your shares at a price close to the market value. In low-liquidity scenarios, however, finding a buyer might be challenging, and the sale may necessitate a more significant price concession.

High liquidity in a stock allows for more efficient trading.

What are considered liquid assets, and what is the most liquid asset? 

Liquid assets can be quickly and easily converted into cash without significant loss in value. An asset’s liquidity is crucial in financial planning, especially when quick access to cash is needed. 

Some common examples are cash equivalents, savings and checking accounts, stocks, and more, but the most liquid asset is cash itself, as it’s already in the form needed to conduct transactions and doesn’t require any conversion or selling process.

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Types of liquidity

Liquidity can be categorized into different types, each significant in various financial contexts. Learning these types helps you understand how to trade, manage, and evaluate assets.

Here are the three most common types:

1. Market liquidity

This refers to the ease with which assets can be bought and sold in a market. High market liquidity means an asset can be quickly sold without causing a significant movement in its price. It's particularly relevant in stock markets, real estate, and other asset markets.

Low liquidity, on the other hand, is typically associated with small caps or infrequently traded assets—like pink sheet stocks—and can result in increased transaction costs and price volatility.

2. Accounting liquidity

While market liquidity is integral to investors, accounting liquidity is crucial for businesses. 

This type assesses a company's or individual's ability to meet short-term financial obligations without raising additional capital. Common measures include ratios like the current ratio, quick ratio, and cash ratio, which compare liquid assets to liabilities. 

• Current ratio: Assesses a company's ability to settle short-term liabilities using its current assets (liquid and less liquid). 

• Quick ratio: Excludes less-liquid assets, and provides a clearer picture of a company's ability to meet its short-term obligations. 

• Cash ratio: Measures a company's ability to pay off its short-term liabilities with its cash and cash equivalents alone.

3. Funding liquidity

This involves an entity’s ability to acquire funds to meet immediate and short-term obligations. For businesses, this could mean accessing lines of credit or short-term loans. In a broader economic context, it refers to the ease with which financial institutions can obtain capital.

Why is liquidity important?

Liquidity in stocks is vital as it signifies the ease with which stocks to trade. But that’s not all. Here are a few other reasons highlighting its vitality:

Ease of trading

Liquidity enables investors to easily buy and sell assets and without substantial price fluctuations. Highly liquid stocks count many market participants, meaning multiple buyers and sellers are available.

Flexibility

Liquidity allows investors to adjust their investment strategies quickly. They can buy or sell positions as market conditions change, leverage opportunities as they emerge, and respond to new information without hassle.

Risk mitigation

Liquidity provides a degree of protection during volatile market conditions. Investors can exit positions even when market sentiment is shifting rapidly, helping mitigate potential losses.

Portfolio diversification

Liquid assets help ensure portfolio diversification, meaning investors can efficiently allocate their funds across various assets without concerns about limited liquidity. They can also assess their liquidity in terms of available or uninvested cash considered a portion of their overall portfolio.

Common among institutional investors

Institutional investors are easily attracted to highly liquid stocks, such as mutual funds, pension funds, university endowments, and sovereign-wealth funds. For obvious reasons, these large investors prefer assets that can be bought or sold in substantial quantities without significant price changes.

Economic functionality

Liquidity is essential for the overall functioning of the financial markets and the economy. It ensures that capital flows efficiently and funds are available for new ventures and lines of business.

How to measure liquidity: Key strategies 

Measuring liquidity helps investors gauge the efficiency and stability of markets and individual securities. While no single measure can capture all aspects of liquidity, traders use several key indicators to establish a comprehensive picture. 

Here are a few methods:

Trading volume

Examine the stock's daily trading volume to know about the number of shares traded daily. Remember, high trading volumes indicate strong liquidity and ease of buying or selling.

Bid-ask spread

The bid-ask spread reflects the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). A narrow spread suggests the stock has high liquidity. Conversely, a wide spread may indicate lower liquidity.

Market depth

Deeper markets feature more substantial quantities at different price points, usually indicating high liquidity.

Assess market depth by analyzing the order book, which displays the number of shares available at various price levels. A well-populated order book suggests traders can easily find counterparties for their trades. 

Average daily trading value

Calculate the average daily trading value by multiplying the average trading volume by the stock's price. This metric offers a more comprehensive view of liquidity, considering both volume and price. Higher average daily trading values generally suggest better liquidity.

Turnover ratio

The turnover ratio compares the trading volume to the total number of outstanding shares. A higher turnover ratio signifies higher liquidity.

Impact cost

Impact cost measures the impact of a large trade’s price on the stock's price. Lower impact costs indicate better liquidity because large trades have a minimal effect on the market price. Stocks with high liquidity tend to exhibit lower impact costs.

Historical liquidity analysis

Review historical data to identify liquidity trends. Consistent high liquidity over time highlights stability and reliability. 

Liquidity ratios

Use fundamental liquidity ratios, like the current and quick ratios, to assess a company's ability to cover its short-term obligations. Company stocks with strong fundamental liquidity ratios often correlate with better stock liquidity.

Trading platforms

Many platforms provide visual representations of liquidity metrics, simplifying the evaluation process for traders.

Examples of liquid stocks

Many investors desire liquidity and look for stocks with high trading volumes, narrow bid-ask spreads, or a consistent presence of buyers and sellers.

Here are a few examples of high-liquidity stocks with their market cap (at the time of writing):

Apple (AAPL)

Apple is one of the most liquid stocks, with a market cap of more than $3 trillion. Its stock enjoys near-constant trading activity, allowing investors to buy or sell large share quantities without significantly impacting its price.

Microsoft (MSFT)

Microsoft is a technology giant with a diverse range of products and services, leading the computing world with a highly liquid stock to match. It has a market cap of almost $2.8 trillion.

Alphabet (GOOGL)

Alphabet, Google’s parent company, also counts as a highly liquid stock. Google's search dominance, billions in ad revenue, and subsidiary companies contribute to its popularity among investors––large and small. It has a market cap of about $1.8 trillion. 

Amazon.com (AMZN)

With a market cap of around $1.6 trillion, Amazon sees huge trading volume virtually every day of the year—arguably every minute of the year. The retail and web services giant is known for its expansive business operations, from cloud computing to entertainment to its own-brand consumer goods.

What is liquidity risk?

Liquidity risk describes the potential difficulty of quickly converting an asset into cash or buying/selling an asset without causing a significant change in its value. This risk becomes particularly prominent in situations where an imbalance between the asset’s supply and demand affects the ease with which transactions can be executed.

To manage it, investors and institutions often maintain a balance between liquid and illiquid assets, ensuring enough cash or cash equivalents are on hand to meet short-term needs. Sometimes, they employ strategies like diversification, liquidity analysis, and up-to-date lines of credit to mitigate risks in their operations and investments.

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