Market liquidity is a measure of how quickly and easily an asset can be bought or sold at a fair price. It is determined by the number of buyers and sellers in the market, as well as the size and frequency of trades.
A liquid market is one with many buyers and sellers and a high volume of trading. This means that it is easy to find someone to buy or sell an asset from and that the asset’s price is likely to be stable. An illiquid market is one with few buyers and sellers, and a low volume of trading. This means that it may be difficult to find someone to buy or sell an asset from and that the asset’s price may be more volatile.
Importance of Market Liquidity
Market liquidity is crucial because it allows investors to enter and exit positions quickly and at a fair price. A liquid market is generally less risky, as there is always someone willing to take the other side of a trade. This attracts speculators and investors, which creates favourable market conditions. In a liquid market, sellers can quickly find buyers without having to lower the price of their assets. Conversely, buyers do not have to pay more to secure the assets they want.
An asset’s liquidity also affects the spread that leveraged trading providers offer. High liquidity means that there are many orders to buy and sell the underlying asset. This increases the likelihood that the highest bid and the lowest ask will converge, resulting in a narrower bid-ask spread. Since we derive our prices from the underlying market, a lower bid-ask spread there will translate into lower spreads on our platform. Illiquid markets can have much wider spreads. Spread means the difference between the bid and ask price.
How to Trade Liquid Market
To leverage liquidity effectively, start by identifying high-liquidity markets, which are characterized by a higher presence of buyers and sellers, making it easy to enter and exit positions. One reliable indicator of liquidity is trading volume, with higher volumes suggesting greater market liquidity. When trading, consider placing stop-loss orders near liquidity levels, typically found at support and resistance points where numerous pending orders accumulate.
This approach helps to minimize potential losses if the market moves against your position. Moreover, for both entering and exiting trades, it’s advisable to choose liquid markets. Trading in a liquid market ensures you can secure favourable trade prices and swiftly exit positions, enhancing your overall trading experience.
For example, let’s say we are trading with a liquid stock currently trading at Rs. 200. We have a target of Rs. 210 and a stop loss of Rs. 194. As the stock price trades down, when it touches the level of Rs. 194, the stop loss order will get executed easily, as there are many buyers. But in the case of an illiquid stock where liquidity is so low, if the stock price trades lower, due to fewer buyers, the price may directly trade at Rs. 190, as there were no buyers at the level of Rs. 194. This can create a huge loss for the trader. In 2nd Scenario, even if the target is hit, but there is no buyer at the level of Rs. 200, the stock will remain in the portfolio, which may later on drop to the buying level, making the analysis and efforts go to waste.
Issue with Small Cap and Penny Stocks
Penny stocks are shares of small public companies that trade for less than Rs. 10 or 20 per share. They are often attractive to investors because they have the potential to generate high returns quickly. However, penny stocks are also highly risky and illiquid.
There are a number of reasons why penny stocks are illiquid. First, they are often traded on over-the-counter markets, which are less regulated and have less liquidity than major exchanges like the NSE and BSE. Penny stocks are typically issued by small companies with limited financial resources. These companies may not have the resources to market their stocks effectively or to attract institutional investors. These kinds of penny stocks are often targeted by fraudsters. This can make investors cautious of trading penny stocks, which can further reduce liquidity.
How to Safeguard your-self from Illiquid Stocks
The daily average volume is the average number of shares traded each day. A higher daily volume indicates that there are more buyers and sellers for the stock and that it is more liquid. A good rule of thumb is to look for penny stocks with a daily average volume of at least 1,00,000 shares per day.
The bid-ask spread is the difference between the highest price that buyers are willing to pay for a stock and the lowest price that sellers are willing to accept. A wider bid-ask spread indicates that there is less liquidity for the stock. Investors should look for penny stocks with a bid-ask spread of no more than 5%.
Investors should review the trading history of a penny stock to look for any unusual patterns. For example, if the stock has experienced a sudden spike in volume or price, it could be a sign of manipulation.
Following are the top liquid stocks of last week:
|Sr. No.||Name||CMP Rs.||Mar Cap (Rs. Cr.)|
|1||I O C L||99.01||139814.39|
|4||Apollo Micro Sys||103.41||2716.19|
Read in Detail: Investing In Penny Stocks: Fact vs. Fiction
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.