Let’s understand what is Liquidity first.

Imagine you own a property in a city like Mumbai. If you decide to sell this house, it is easy to find prospective buyers as there will be demand for real estate in Mumbai.

Now let’s assume you have another property in your native village at a very remote place. It is hard to find buyers for property in a village compared to Mumbai.

So, the ease of finding buyers and sellers for any investment is called Liquidity.

Here the property in Mumbai is said to have higher liquidity and the one in the native village would be said to have a Lower Liquidity.

Liquidity varies by asset class: Cash is of course the most liquid asset followed by gold, stocks and then property. Something obscure like modern art will have little or no liquidity because it is much easier to find buyers for gold than modern art.

Why is Liquidity Important:

Higher liquidity ensures:

• Ease of buying and selling
• Better prices at entry and exit
• Less stress of finding prospective buyers
• Quicker availability of cash whenever you need

Liquidity in Stocks:

Going by the same definition of liquidity, a stock that has more prospective buyers and sellers would be called a liquid stock whereas a stock that has fewer buyers/sellers would be called an illiquid stock.

Surprisingly, there is no official measure of liquidity.

Therefore, we have to use practical knowledge to assess liquidity in stocks.

Here are a few important criteria that you can use to determine liquidity:

1. Market Capitalization:

Market capitalization essentially implies how big or small a company is.

A basic thumb rule is: the higher the market cap of a company, the higher will be the liquidity in that stock.

So the large-cap stocks have the highest liquidity – much more liquidity than the mid & small caps. Examples of large caps stocks would be Reliance, TCS, L&T, HDFC Bank etc.

When it comes to mid-caps, the range of liquidity is quite wide.  Some mid-caps have very high liquidity whereas some have much lower liquidity. In any case, mid-caps have lower liquidity than large caps. Examples of mid-cap stocks are Mind tree, Apollo Hospital, Indian Bank etc.

Small-cap stocks have the lowest liquidity. Examples of small caps would be South Indian Bank, Jagran Prakashan, Chennai petroleum etc.

Now, the small caps stocks that have very low market cap are also called micro caps and these stocks are the worst when it comes to liquidity.

When the markets are bullish, people make a lot of money in these stocks but when the market starts correcting, it is very hard to find buyers for these stocks and therefore the correction in these stocks can be brutal. For example, throughout 2018, the small caps corrected by as much as 50-80% whereas large caps fell about 10-20%.

Therefore, my advice always is to stay away from micro caps, but if you do want to invest in them, it is better to go via mutual funds.

2. Spreads:

Another practical way of determining the liquidity of stocks is to check their spreads.

Spread is the difference between the Bids and Asks. In a highly liquid stock, these spreads tend to be very small or tighter as they are called. In low liquidity stocks, these spreads can be wider.

3. Intraday Charts:

A third and very visual way of assessing the liquidity of a stock is to look at its Intraday charts.

You will find that the prices of liquid stocks tend to flow in a sense with almost no price interruptions.  Compare that to the chart of an illiquid stock and you can see that the chart looks like someone has put sticks on a paper.

So just to recap, we learned the concept of liquidity, its importance in the stock market and of course and ways of checking the liquidity of any stock.

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