What is liquidity?

What is liquidity?

Liquidity is used in finance to describe how easily an asset can be bought or sold in the market without affecting its price – it can also be known as market liquidity. When there is a high demand for an asset, there is high liquidity, as it will be easier to find a buyer (or seller) for that asset.

Cash is considered the most liquid asset because it is very stable, can be readily accessed and easily spent. Therefore, cash is commonly used to gauge the liquidity of other markets. For example, the liquidity of a stock is measured by how quickly and easily it can be converted to cash. If it is difficult to convert an asset into cash, then it is considered illiquid.

One way to evaluate the level of market liquidity is by observing the bid/ask spread – as the liquidity of an asset increases, the bid/ask spread usually tightens.

Liquid markets

In a liquid market it is easy to execute a trade quickly because there are numerous buyers and sellers. For instance, with a daily trading volume of over $5 trillion, forex is considered the largest and most liquid market in the world.

Large stock markets, such as the New York Stock Exchange, are also considered highly liquid because thousands of shares change hands every day. But the liquidity of an individual stock can vary depending on factors such as its market capitalisation, the exchange its shares are traded on and whether it is included on an index. Usually blue-chip stocks such as Microsoft, Google and Apple will be extremely liquid.