Let’s say you own 2 properties. One in the middle of a busy city like Mumbai and the other in a remote village. If you decide to sell these properties which of these two do you think would be easy to sell? Of course, the first property because there would be many more people interested in buying a property in Mumbai than in a remote village. 

Liquidity is defined as the ease of entry and exit into an investment. Using that definition, the property in Mumbai would be called to have higher liquidity than the property in the remote village. In simple terms, higher liquidity implies that more people are interested in buying or selling.

The concept of liquidity applies to all kinds of investments: property, stocks, gold, fixed deposits, cash and even something like modern art.

An investment where there is a higher investor interest is called “liquid” and investments, where the investor’s interest is much lower, is called “illiquid investment”. Gold and cash are liquid whereas property and modern art are illiquid.

Liquidity in Stocks

On the same principle, stocks can also be classified as liquid and illiquid. A liquid stock is one where there is a higher buying and selling interest and illiquid stock is one where there are very few buyers and sellers. Now the question is why is liquidity important?

Illiquid stocks have three main limitations:

• It is harder to exit in the stocks. It means that it’s very hard to find buyers when you want to exit that particular stock.
• The spread is wider
• They are prone to manipulation

How to check liquidity

The next question comes how to check liquidity in stocks.

The first method of checking liquidity is by the market capitalization of the stock stocks such as ICICI Bank and Reliance Industries. Stocks with higher market capitalization tend to have higher liquidity and stocks with low or micro-market capitalization tend to have lower liquidity.

The second method is by looking at the spreads. “Spread” is defined as the difference between the bid price and the asking price.  If the difference is larger it would imply that there are fewer buyers and sellers in the market and hence that stock is illiquid.

Liquidity also varies by the instruments. In options, At The Money (ATM) options have higher liquidity than out of the money (OTM) and in the money (ITM) options. In the Indian stock market, index options have higher liquidity than stock options on similar lines futures have lower liquidity than cash markets.

Another way of checking the liquidity of the stocks is to look at their intraday charts. The charts where the price seems to be flowing across time would be called liquid stocks where are the charts like these where the price moment is lumpy would be called illiquid stocks.

Liquidity carries different implications what investors and traders. Liquidity is important to investors especially when they are investing in micro caps. When the market is down or the investor sentiment is negative it is very hard to find buyers for small and micro-cap stocks. In these situations, selling an existing investment becomes difficult because the prices can vary significantly this happened very prominently during the first half of 2018 where exiting micro-cap stocks was almost impossible.

Liquidity is far more important to traders. The shorter the time horizon of the trade the more important liquidity becomes. That means liquidity has much more significant for an intraday trader as compared to a positional trader. Liquidity also ensures that they can easily enter and exit out of the trades and they are not trading in stocks that are operator driven.

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