What Is Market Liquidity
Hello, traders. Welcome to the stock trading course and the third module, how the stock market works. In this lesson, we are going to talk about illiquid markets and liquid markets. This is a very important lesson to take before moving forward in the path of becoming a stock trader because the market liquidity is going to be one of the biggest factors when it comes to decide which stock we are going to be trading. So, let’s start by defining what market liquidity is. Market liquidity is the market’s ability to facilitate the purchase or sale of a security without causing dramatic changes in the security’s price. So, when we talk about market liquidity, we have to talk about how liquid a market is. And a liquid market is a market with many bids and asked offers. This means that the book, or the order book is thick with many offers to buy and sell the stock at different prices.
Liquid markets normally have low spreads and low volatility, and when it comes to more liquid stocks, you are going to find spreads as low as one cent. But when it comes to illiquid markets, this is not the case. And because there are many bids and offers on the book with a low spread, there is low volatility when it comes to trading these markets. This means that, because the book is thick, big orders to buy or sell their security won’t have an impact on the security’s price…well, won’t have a very big impact on the security’s price. This is why we are going to be focusing more on liquid markets. In liquid markets, it’s easy to execute a trade without any slippage, and this is important. When you plan your trade, you plan your entry level, you’ll need…or, well, to get the perfect [inaudible 00:02:13] according to your plan, you need to get in at the exact price level that you want to. And in a liquid markets, you are not going to get any slippage because there are a lot of traders on both side of the market offering to buy or sell the stock. So, you’re not going to have a problem of slippage. Remember that slippage is…well, the definition of slippage is that when you enter a trade at a price, but because there are no offers or at that price, you get fill at a higher price, for example, and you got a slippage in your price entry.
So, an illiquid market is the opposite of what we just saw. In an illiquid market, the bid and ask offers are very thin. That’s why we call it a thin market too, which leads to have large spreads. Sometimes, spreads in illiquid markets can go up to five dollars. Due to how thin the order book is, a big order will have a large impact on a security’s price. So let’s imagine that we are looking at a very thin book, or a very thin stock, and you only have two large…on the ask side, at the best ask, then you have one lot at the next level, e.t.c. An order of 100 lots is going to move price up through all these levels, and is going to have a much larger impact than on a liquid market where we might have a 100 lots on the ask side. It’s also more expensive to trading them to large spreads.
So, what kind of stocks are we going to look to trade? And remember that we are only looking at the liquidity side of the stock, for the time being. We are going to look to trade very liquid stocks. The stock price is really not important. I mean, I don’t care if you trade $20 stocks, $100 stocks, blue chips, whatever. The price stock is really not important in this lesson, what we are going to focus is liquidity. So, we are going to focus on stocks that trade more than 500,000 shares per day. Stocks that trade 500,000 shares per day and lower are considered thin stocks, and we are going to stay away from them. On these stocks, the book is thick enough for us to have immediate fills and no slippage. So, we are going to start by locating stocks that trade 500,000 shares per day and more for liquidity issues in our trading.