Liquidity of Stocks: What It Is and Why It Matters
Introduction
The liquidity of stocks defines how quickly and at minimal costs one can buy or sell a security on the market. Even with strong fundamental indicators, low liquidity can negate all advantages, as a trader may face wide spreads, high slippage, and the risk of not closing a position timely. Understanding the mechanisms of liquidity allows for building safer and more effective strategies, thereby reducing costs and risks.
1. Definition and Types of Liquidity
1.1 Market Liquidity
The liquidity of stocks refers to the market's ability to maintain a proportional supply and demand without sharp price declines. Market liquidity is formed through exchange trading and the order book. Highly liquid securities allow for quick entry and exit.
1.2 Over-the-Counter Liquidity
Over-the-counter liquidity arises when there is insufficient volume in the main order book. Brokers and market makers create pools to eliminate shortages in demand or supply at favorable prices.
1.3 Absolute and Relative Liquidity
Absolute liquidity is measured by trade volumes, while relative liquidity is assessed through spreads, slippage, and execution costs. For a portfolio investor, liquidity is a guarantee of the ability to rebalance quickly, while for a scalper, it is a matter of survival.
2. Market Depth and Spread
2.1 What is Market Depth
The order book is a list of limit orders to buy (bid) and sell (ask) with prices and volumes. Market depth shows how many shares are available to buy or sell at various prices, which mitigates shocks during large orders.
2.2 How to Read the Order Book
When analyzing, pay attention to large volume clusters that may become support or resistance zones. They can help predict where the price might halt its decline or rise.
2.3 Bid/Ask Spread
The difference between the best buying and selling prices. A narrow spread (<0.1%) is typical for blue chips, while a wide spread (>1%) is found among low-cap issuers and in secondary markets.
2.4 Impact of Spread on Trades
The spread affects the cost of each trade: entering at the ask and exiting at the bid "eats" into profit. For intraday strategies, even a 0.05% spread can be critical.
3. Liquidity Metrics: Volumes, Turnover, Slippage
3.1 Average Daily Volume (ADV)
ADV indicates how many shares pass through the exchange on average per trading day. An ADV >1 million shares allows larger players to execute trades without significantly impacting the price, while an ADV <100,000 shares signals a high likelihood of slippage.
3.2 Turnover Ratio
The ratio of annual trading volume to market capitalization. A ratio >1 indicates active interest from participants and the market's ability to quickly digest large volumes.
3.3 Slippage
The difference between the expected (limit) and actual (market) execution price. During periods of low liquidity, slippage can reach several percent. Using limit orders can help mitigate losses.
3.4 Volatility
High volatility during low liquidity exacerbates slippage. An ATR above the sector average and VIX >30% alongside low ADV signals a need to reduce entry volume.
4. Risks of Insufficient Liquidity
4.1 Significant Slippage
Even with small volumes, a market order may execute far from the average price, reducing expected profits or amplifying losses.
4.2 Market Manipulation
With low market depth, small volumes can artificially "pump" the price and then sharply "dump" it, misleading participants.
4.3 Inability to Liquidate Quickly
During moments of panic and news shocks, trading slows sharply, leading to significant price jumps and the inability to close a position at the desired price.
4.4 Expanded Spreads Outside Trading Hours
In over-the-counter markets and during the European session, liquidity drops, and spreads widen significantly, making trades particularly costly.
5. Algorithmic Trading and Execution Optimization
5.1 VWAP Algorithm
This breaks down volume proportionally to the average daily trading profile, helping to execute large orders without significantly impacting the price.
5.2 TWAP Algorithm
Evenly distributes volume over time and is suitable for calm markets where the goal is to minimize the time impact on the price.
5.3 Iceberg Orders
Conceal the total volume by displaying only a small "peak" portion of the order. The remaining part is submitted as the first part gets executed.
5.4 Sniper Algorithms
They monitor for large limit orders or anomalies in the order book and respond instantly, optimizing entry and exit points.
6. Measurement Methods and Analytical Tools
6.1 VWAP (Volume Weighted Average Price)
The volume-weighted average price over a period. Execution below VWAP is considered favorable for a trader, as it indicates a better price compared to the market.
6.2 TWAP (Time Weighted Average Price)
The average price over a time segment without taking into account volume. Useful in uniform markets, where the primary goal is to minimize time risk.
6.3 Volume Profile
Shows the distribution of volume across price levels over a selected period, identifying key areas of supply and demand.
6.4 Market Impact Cost
An estimation of how much the volume of an order impacts the price, calculated based on spread dynamics and execution volumes.
7. Strategies for Managing Liquidity and Diversification
7.1 Selection of Underlying Assets
For core positions, stocks with an ADV >500,000 and a spread <0.2% are preferred, providing a balance between yield and costs.
7.2 Diversification by Instruments
Adding ETFs and futures with high liquidity to a portfolio allows for hedging positions in low-turnover stocks.
7.3 Limit Orders and VWAP Execution
Reduces the average entry price by algorithmic breakdown and minimizes slippage.
7.4 Timing and Window Trades
Breaking down large orders into several time windows helps to mitigate intraday liquidity anomalies.
7.5 International Markets
ADRs and GDRs may have higher ADV compared to local listings, expanding opportunities for large trades.
Conclusion
The liquidity of stocks is a key factor influencing the costs and safety of trading operations. Market depth, spread, volumes, slippage, and volatility are fundamental parameters for assessing liquidity. Algorithmic strategies (VWAP, TWAP, icebergs, snipers), liquidity diversification, and smart timing assist in optimizing execution and protecting capital in a dynamic market environment.
