Every
equities trader,
CFD trader,
Option trader or
futures trader (or share investor) should take time to understand Market liquidity. Market liquidity refers to the ability to buy or sell a particular asset without causing a significant movement in the price. The essential characteristics of a liquid stock is that there are a significant number of ready and willing buyers and sellers at all times. Stock liquidity is an important consideration in short term share trading, as the lack of liquidity can decrease your profit, or worse, increase your loss. Indicators that can be used to asses the liquidity of a stock include: market depth, slippage, spread, stock volume and stock turnover.
Market depth displays orders that are currently in the market. Click onto the following link
to view a market depth example. At the top level of the market display screen are the orders that are closest to the trading price. When two orders match, that is, a buy and a sell order at the same price, the orders are filled and they disappear from market depth. When liquidity is low then slippage can occur.
Slippage is the difference between the last traded stock price, and the price that the stock actually costs to buy or sell. Slippage is an important consideration when moving from simulated paper trading to real trading, as the prices attained on a "real" trade may not match those chosen in a "paper trade". Slippage is typically amplified for small cap stocks as liquidity is often low.
For example, If you were to say to your broker that you wanted to buy $30,000 of BHP 'at market' then you would pay $27.70 (assuming that is the last close price) or maybe a cent or two above. Given the liquidity of BHP, slippage is normally much lower. However if you wanted to buy $30,000 of Ansearch (ANH) then your purchase would be around 1/4 of the average daily volume of the stock and would take a lot of the available depth, meaning that you would start paying 6c and possibly end up paying 10c or more. This is a 40% range.
Remember, it is always easy to buy into a stock, however, exiting (selling) a stock is often more difficult on low liquiditry stocks, which suggests the a lower profit than anticipated or a larger loss. Slippage can cause
stop loss selling in stocks.
The
spread is the difference between the bid and ask price of a security. The spread is determined by the demand or interest in a stock. The less the demand, potentially the greater the spread and vice-versa. The demand of a stock is indicated by its volume and turnover.
Put simply the higher the average daily volume then the higher the liquidity. The higher the liquidity the greater the stock market turnover. High liquidity ensures that at the moment when we want to buy and sell shares, there will be enough sellers/buyers available.
However, sudden rises in the volume for smaller cap stocks that are not attributed to any fundamental announcements made by the company should be viewed with extreme scepticism. A possible explanation could be 'pump and dump' schemes. This involves the touting of a company's stock (usually small-cap) through false or misleading statements made to the market place, then as buyers move in the 'pumper' sells and makes large profits. You can read about
pump and dump in more detail here.
Concluding Notes * Trade only stocks that over a long period of time have had high average turnover and volume.
* Low Volume stocks will normally have a wider spread between bid and ask prices.
* Market depth will help to give you an idea of the liquidity of a stock at any one point in time.
* Beware of extreme stock volume movements for small cap stocks that have no fundamental reasons behind the increase in volume.