Liquidity

Liquidity is a term used to describe how quickly and easily an asset or security may be converted into cash. From real estate holdings to shares of corporate stock, degrees of liquidity vary significantly in relation to a broad spectrum of factors. Public interest, supply/demand levels, and macroeconomic cycle are a few broader issues that determine an asset's relative liquidity.

Aside from applications in the marketplace, liquidity is also a valuable consideration in both personal and corporate finance. It is frequently used in reference to whether or not an entity is able to meet any financial obligations. Ratio analysis is a common way of measuring financial liquidity, and it's an integral aspect of balance sheet and income statement analysis.

Another facet of liquidity is its standing in the capital markets. The distinction between "liquid" and "illiquid" securities is vast, as each attribute has a wide range of strategic implications. Given the evolving relevance of market liquidity, it's an important concept for active traders and investors to thoroughly comprehend.

Market Liquidity

For active traders and investors, selecting an ideal product to engage typically involves a scrutiny of liquidity. In fact, the effectiveness of many strategies is often correlated to a security's "depth-of-market" or "market depth."

Market depth is the number of open orders local to a specific product. Securities that exhibit a high number of open buy and sell orders have strong market depth and are said to be "deep." Deep markets are inherently liquid and able to absorb new inflows of orders without becoming unhinged. Given this attribute, securities that exhibit robust market depth are relatively stable and may be used to augment trading efficiency.
Any number of fundamental factors can influence the depth and liquidity of currency, commodity and equities markets.

Time of day, news cycle and institutional participation all contribute to the number of buyers and sellers actively engaging the market of a security.

Liquid markets are frequently targeted by forex, futures and equities traders. These venues afford participants three key advantages:

Tight Bid/Ask Spreads

Deep, liquid markets feature an abundance of buyers and sellers, so bid/ask spreads are typically tight. For instance, EUR/USD traders enjoy ultra-low low spreads as the number of bids and asks hitting the market at any given time is immense. Conversely, participants in exotic pairs such as the USD/TRY are forced to deal with limited market depths and the increased costs of wide spreads. Subsequently, trading liquid markets is more affordable due to consistently tight bid/ask spreads.

Limited Slippage

One of the top benefits of trading liquid markets over illiquid ones is limited slippage. Slippage occurs when a market or stop-market order is filled at a disadvantageous price. The cost of slippage can be substantial in illiquid markets, as reduced depth undermines efficient trade execution. For strategies that involve a large number of trades and precision, slippage is a critical factor influencing profitability. As a result, traders focus upon liquid markets to ensure that orders are regularly filled at desirable prices.

Pricing Volatility

Enhanced participation rates typically lead to fluctuations in pricing, thus creating trading opportunities. While illiquid markets can produce unpredictable moves in price, deep markets offer consistent volatility. This is a major benefit afforded to technical traders, as reliable order flow contributes to the validity of applied indicators and tools.

In practice, high degrees of market liquidity promote trade-related efficiency. Given this consideration, many strategies are designed specifically to engage those markets that exhibit consistently strong participation. The following are two indicators used to identify the markets/products most likely to facilitate efficient trade:

  • Open Interest: Open interest is the number of outstanding shares or contracts in the market of a security at a specific point in time. This indicator is used to project future participation levels and quantify the activity present in a market. Generally speaking, as open interest grows, a product's perceived liquidity increases.
  • Traded Volumes: Traded volumes are the number of shares, lots or contracts that have changed hands for a given period. For instance, the forex boasts a tremendous daily traded volume in the trillions of pounds, which ensures robust market liquidity.[1] On the other hand, products such as live cattle futures contracts trade with vastly reduced volumes. In contrast to the major forex pairings, live cattle futures display an average daily volume measured in the thousands of contracts.

The general rule of thumb relating liquidity to volume and open interest is as follows: the greater the volume and open interest, the more liquid the market.

Perhaps the most important aspect of liquidity is how it impacts value. In the event that an asset or security is not readily exchangeable for cash, it is deemed illiquid and loses value. This can have dire consequences for the asset holder (seller) as any compensation received in an exchange is not likely to equal the asset's full value. Illiquid assets or markets are not ideal for active traders, as efficiency is compromised due to wide bid/ask spreads and high degrees of slippage stemming from limited participation.

Measuring Liquidity: Ratio Analysis

While open interest and traded volumes are used to determine a market's liquidity, ratios are frequently used as measurements for individuals and companies. These metrics relate assets and cash to liabilities, creating a picture of solvency or insolvency. Ratios play an integral role in fundamental analysis, especially as it pertains to the trade of equity products.

The following are three commonly used financial liquidity ratios:[2]

  • Current Ratio: (Current Assets)/(Current Liabilities) The current ratio measures an entity's ability to fulfill short-term obligations. It provides a broad look at financial health without the specificity of asset types, business sector or economic cycle.
  • Acid-Test Ratio: (Cash + Accounts Receivable+Cash Equivalents)/(Current Liabilities) Also known as the quick ratio, the acid-test ratio is used to quantify an entity's ability to pay its short-term debts. The acid-test ratio focuses on cash reserves instead of more illiquid assets such as inventories or other physical property.
  • Cash Ratio: (Cash + Cash Equivalents)/(Current Liabilities) The cash ratio is commonly used by creditors to establish an entity's ability to quickly pay off debts. It is a conservative look at liquidity in that cash-on-hand is the primary asset under consideration.

The consequences for a company or individual being deemed illiquid can be substantial. In both cases, credit worthiness is negatively impacted. In the case of corporate stocks, share prices can plummet due to insolvency. For individuals, securing loans or lines of credit becomes exponentially more difficult.

Summary

Liquidity is a key element of both active trading and finance. In the marketplace, it promotes efficient trade and is vital to the success of a broad spectrum of strategies. As it pertains to traditional financial theory, it is the ability of an entity to meet its obligations. In either case, high degrees of liquidity are viewed as being positive characteristics, promoting efficiency and solvency.

This article was last updated on 17th July 2020.