Investors consider many factors while investing in different financial markets, including the rate of return, stock prices, interest rates, growth, risk, and stock market liquidity.
Is your money tied up, or would you consider it accessible, especially when you need it? That is one way you can view stock liquidity.
Liquidity also affects whether or not an investor will pay higher or lower transaction costs while investing. Will the transaction flow smoothly down the river (high liquidity), or will a dam block it (low liquidity)?
Stocks listed on Wall Street are not built equal. The supply and demand are different, just as with any other product or service marketed. The majority can be considered liquid investments, but what about the rest?
Defining Liquidity: What Is It?
Investors want to be successful and make a profit, period.
To make money and be rewarded by the stock market, you need to learn the rules of the game. Liquidity plays a part in it.
The most liquid asset of them all is cash, followed by assets that you can convert to cash quickly.
When a stock is liquid, there is little to no effort involved in buying or selling it. This is also referred to as market liquidity. A highly liquid stock is popular, and people want it. The market price doesn’t fluctuate much either during the transaction.
So, what does an illiquid market look like?
In this case, the reverse is true — the stock becomes illiquid. An investor may be holding onto shares for a long time, risking losses and a more extensive bid-ask spread. This is also known as liquidity risk.
Why Is Liquidity Important?
Liquidity affects the profitability of stocks.
Market volatility is affected by economic events, too. All it takes is for the market to crash to hold trading or risk stocks delisting from the exchange.
Two factors determine the liquidity of a stock:
- Price spread (or Bid-Ask spread)
What Is a Bid-Ask Spread?
Bid-Ask Spread can be broken down into two components: the bid and the asking price.
A bid refers to the highest price a buyer is willing to pay. Think of it like an auction. People are interested and have a maximum price in mind.
The ask is in the seller’s court. That’s the lowest price the seller is willing to part with the stock.
When stocks are liquid, the spread is small. When they are illiquid, the spread can travel for miles.
But, look at the bright side. Investors can be successful with illiquid stocks because there’s always room to negotiate.
What Is Slippage?
Slippage is bound to happen to all investors. It is the difference between what price you expect to buy or sell stock shares at and the final cost.
Slippage occurs with market orders. This is one way to place a trading order, buying or selling as quickly as possible at the market price.
Limiting orders can help you combat risks. As the name suggests, the buy or sell order is placed with set parameters and a minimum and maximum price. This gives the investor more control over the transaction.
How Can You Identify Higher Liquidity?
You can look for these indicators to identify whether or not a stock is liquid.
Is the Bid-Ask Spread High or Low?
When bid-ask spreads are at their lowest, consider stocks liquid. There won’t be room for negotiation since the market is hot, and there are many people interested in buying and selling.
When bid-ask spreads are high, be cautious.
How does the average daily trading volume (ADTV) look?
At their highest, the bid-ask spreads will be low; the stocks will appeal to investors. Trades should be smoother, as this metric shows that there are numerous buyers and sellers out there.
Highly liquid stocks trade:
- 100 times a day or more on average
- Carry an average trading value of $1 million or greater each day
Stock floats indicate the number of shares available to investors to buy and sell on stock exchanges. The float itself doesn’t impact investors, but the percentage shows a company’s ability to create new shares.
For example, a low float percentage on a stock translates to possible liquidity concerns. Low float means that outstanding shares are sparse. Therefore, the trading volume may be low.
You can use a handful of metrics when evaluating whether or not a stock is liquid. Most are calculated based on a company’s financials, or accounting liquidity, giving a more precise picture of whether or not a company can fulfill its short-term debt obligations.
Liquidity ratios include:
- Cash ratio = (Cash + Marketable Securities) / Current Liabilities
- Current ratio = Current Assets / Current Liabilities
- Quick ratio, or Acid test ratio = (Cash + Accounts Receivable + Marketable Securities) / Current Liabilities or Current Assets - Inventory / Current Liabilities
- Operating cash flow ratio = Cash Flow from Operations / Current Liabilities
Investors look closely at these ratios to verify that a company has financial stability. A company should be able to pay its short-term obligations and properly allocate its capital for growth.
Some of the most liquid stocks on the market are large-cap stocks. These are stocks from companies with a market value of $10 billion or more, such as Apple, Amazon, Microsoft, and other household names.
Large-cap stocks are also referred to as growth stocks. They are generally a safer investment than small or mid-cap stocks.
Mid-cap stocks include companies with market values between $2 billion and $10 billion. Are they liquid? Yes, some are — but not as liquid as large-cap.
Small-cap stocks include companies with market values between $300 million and $2 billion. They are the least liquid compared to large-cap and mid-cap stocks. There is a strong potential for shares to be unavailable to buy or sell at a favorable price.
What Are the Most Liquid Assets or Securities?
Stocks are not the only assets labeled as liquid on the market. Other common liquid assets available include:
Examples of Highly Liquid Assets
- Cash: Accessible at the touch of a button
- Checking or Savings Accounts: Money in your checking account is a swipe away with debit cards. Savings accounts may be harder to get to if you need to be at the bank counter to withdraw funds.
- Treasury Bills or Bonds: These are backed by the full faith and credit of the U.S. government. Because of this, you don’t need to wait for maturity and can sell your bonds on the secondary market instantly if needed.
- Certificates of Deposit (CDs): These can fall into both categories — liquid and illiquid. CDs earn a higher APY than traditional savings accounts but can be tied up for a pre-determined amount of time. There are no-penalty options if you are willing to accept a lower APY.
- Bonds: These are tradeable on the secondary market prior to reaching maturity.
- Exchange-Traded Funds (ETFs): These fall into the same bucket as stocks. They can be traded daily and cashed in quickly.
- Mutual Funds: Unlike stocks, mutual funds are traded once per day, but funds can be made available within one business day.
- Money Market Funds: These funds only include liquid assets (cash, CDs, and government-backed debt). They fall along the same lines as mutual funds, having cash available within one business day.
- Precious Metals: Precious metals, such as gold and silver, are tradeable in physical form (bars and coins), by stock shares, and more. Gold bars, for example, are essentially a form of currency and are exchanged for cash through dealers. What makes them illiquid is where they may be stored.
Examples of Illiquid Assets
- Real Estate: This one is tricky and depends on the demand in the market. In some cases, real estate sells in days or weeks, and in others, it could take months or years.
- Stock Options: Companies may offer these to their employees as a benefit/incentive. However, it could take several years of service to own the stock awarded.
- Collectibles: These are not easy to value. Selling requires the right buyer, and buying requires finding a seller.
- Intangible Assets: This category includes intellectual property, goodwill, and brand recognition. Assigning a market value takes time. Although valuable, these are highly illiquid.
- Estates: Before an estate has value, associated debt and taxes need to be paid or settled.
- Private Equity: Investors have the opportunity for large gains, but the funds have restrictions, including when you can sell them.
The Bottom Line
As an investor, you are in the market to grow money, not lose it. Familiarizing yourself with liquidity keeps you ahead of the game.
Liquidity helps you manage your portfolio’s level of risk. It tells you whether you’ll be able to buy and sell (open or close) quickly, turning your assets into cash.
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