Market liquidity - What are liquid markets?
Surely, you have come across numerous financial news talking about market liquidity, but do you really know what market liquidity means or what liquid markets are?
In this article, I cover:
What does market liquidity mean?
What is market liquidity and why does market liquidity matter?Let’s define what is meant by the term market liquidity. When we talk about liquidity in any financial field, we refer to the ease and speed with which we can buy or sell a certain asset at a more or less stable price. If we talk about our day to day, a person or business will be considered liquid if it has the capacity to meet its most immediate financial obligations.
↳ Long-term ability to pay is called solvency.
If we talk about solvency, we can get into the difference between solvency, market liquidity and funding liquidity, which is the ability of a company to make timely payments (can be via credit). But, in this article, I’m going to focus on market liquidity.
If we talk about liquidity in the market, it will largely depend on the number of buyers and sellers that are present in it.
▶ Logically, the more participants there are, the easier we can 'place' our asset. And the more liquid an asset is, the faster we can sell it.
Given this, we can affirm that cash is the most liquid asset because we can exchange it at any time for any product or service. However, a home or a car is not very liquid because they’re not easy to exchange. They require time, price calculations and, almost always, intermediaries.
This is how we define market liquidity. In the world of trading, concepts such as liquidity, spread, lot, are the order of the day. If you want to know them in depth, with trading strategies adapted to all levels, register for our Zero to Hero trading course for free:
Market liquidity vs illiquidity - Why is it important in trading?
When we decide to jump into the world of trading, it’s very important for our capital that we take into account the liquidity of the market in which we want to operate. Why does market liquidity matter?
➨ First of all, because the more liquid the market is, the less risk we will assume since there will always be someone willing to buy or sell.
➨ Secondly, the more liquid the market, the more participants it will attract, which will always facilitate the opening of different operations, depending on our interests.
Additionally, in trading, liquidity can directly affect the spread that we pay the broker to operate a certain instrument. When measuring market liquidity, a liquid market is one that has many daily operations and is made up of many active traders. This will narrow the difference between the purchase (ask) and sale (bid) prices of a given financial asset and, therefore, the spread will be smaller. These are some reasons why market liquidity is important.
Let's take a practical example of how greater liquidity makes trading easier by involving less cost.
↳ If we trade the most liquid currency pair, the EUR/USD, the typical spread with Admirals UK Ltd is 0.6 pips, with no additional fees.
↳ However, if we operate with a less liquid asset, such as stocks, the cost will be somewhat higher. On the IBEX35, Telefónica is one of the most liquid securities: with Admirals you can invest in its shares with a typical spread of 2 pips.
When we choose to operate in a market considered very liquid we must also take into account the trading hours. The reason is that there will not be the same number of participants at one hour as there are in another.
↳ For example, the currency or Forex market is considered to be one of the most liquid. However, if we operate with the EUR/GBP pair, it will not be as liquid during the European session as it will be in the Asian session or holiday periods.
Also, when sellers outperform buyers or vice versa, it can complicate operations and we may not be able to close our position successfully.
One of the reasons the last financial crisis broke out in 2008 was the lack of liquidity of so-called junk or subprime mortgages. Although the current context is very different, in early 2020, the European Securities and Markets Authority (ESMA) warned of liquidity risk in the real estate sector:
"Many of the funds in the real estate sector offer daily liquidity, which indicates a risk of structural vulnerability, since they invest in illiquid assets but allow investors to exchange their shares in a short period of time."
Market liquidity - Which markets are the most liquid?
As I’ve explained above, cash is the most liquid asset of all because we can exchange it for practically any other asset whenever we want. Hence, when we talk about liquid markets we are referring to how quickly we can convert assets into cash.
Let's see below which markets are the most liquid:
Before talking about Forex market liquidity, let's see what exactly this market consists of.
The Forex market is where currencies are traded. According to the Bank for International Settlements (BIS), this market moves 6.6 trillion dollars a day, a figure that can already give us an idea of its liquidity.
▶ Most have participated in this market, just by exchanging one currency for another when preparing a trip abroad, for example.
In addition, we must bear in mind that this market is open 24 hours a day, five days a week: it opens on Sundays at 11 pm, Central European Standard Time (GMT +1) and closes on Fridays at 10 pm.
Currencies are traded in pairs. For example, the EUR/USD measures the value of the euro against the US dollar. When the value of the pair increases, it means that the value of the euro increases against the dollar. If its value falls, it means that the dollar is strengthening against the euro.
Forex pairs are divided into three categories according to their trading frequency and volume and, therefore, their liquidity:
|These are the pairs made up of USD, EUR, JPY, GBP, CHF, CAD, AUD, NZD
|Those pairs that do not include the USD but do include at least one of these three major currencies: GBP, EUR and JPY
|Anything that is not among the above currencies. For example, MAD (Moroccan Dirham) or QAR (Qatari Rial)
Logically, the pairs formed by major currencies are the most liquid because they are the most traded.
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Raw materials / Commodities
At first impulse, we might think that raw materials are not a very liquid market since physical delivery could delay the exchange of cash. However, currently, the so-called commodities are traded through derivative products, such as Contracts for Difference (CFDs), futures or Exchange Traded Funds (ETFs), so they have a lot of liquidity.
The most liquid commodities are those that are traded most frequently:
Gold is the most liquid of all, even though nowadays no country uses this precious metal as a monetary reference.
Investors turn to gold for its stability in times of instability and uncertainty, which is why it is considered a safe-haven asset. On the other hand, the trading volume is also maintained by demand from the jewellery sector and other sectors, such as electronics.
This is the second commodity market with the highest trading volume, behind oil.
In this market, there is speculation about the evolution of coffee prices, which depend on world demand, production, the climate in the areas where it’s grown and the movement of the USD.
Large drilling companies, both public and private, and airlines, governments, and other entities participate in the oil market. This means that the trading volume is very high and, therefore, there are many buyers and sellers that facilitate liquidity.
In this sense, we must bear in mind that crude is used not only as fuel but also to make plastics, fertilizers and even cosmetics.
What is stock market liquidity? There is a link between market liquidity and trading activity. As you can imagine, the most liquid stocks will be those with the highest trading volume. That is, those that can be exchanged quickly because there are many sellers and buyers operating with them. This is what liquidity is in the stock market.
Large-cap companies listed on the world's major stock indices are the most liquid because many of their shares are exchanged in just one session.
As of August 2020, the companies with the highest market capitalization on the IBEX35 are Inditex, Iberdrola and Santander.
Market liquidity - Which markets are the least liquid?
The least liquid assets are those that present the greatest problems when selling or exchanging them for another asset quickly and at a more or less stable price.
These are some examples:
- Homes. The price of a house depends not only on supply and demand but also on the current economic cycle. From the moment one is put up for sale to the moment someone buys it, months can pass.
- Cars. When we buy a car we cannot expect it to be a long-term investment, as could happen with a house, since each year that passes its price drops when calculated taking into account its age.
- Electronic devices (mobile phones, televisions, household appliances, computers, etc). Like cars, these assets depreciate with use.
The best way to learn all about financial markets is with a demo trading account. When operating with virtual funds there is no risk. Practice is very important!
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