Updated: Jan 11, 2021
No, it's not someone selling liquids in a farmers market. And it's not someone selling stocks in the market either. Side note: if you live in New York City or are planning on going, the farmer markets are amazing.
Liquidity and Risk
Liquid markets in this sense refers to liquidity; the varying degree of how quickly an asset can be converted into cash. The higher the liquidity, the easier it is for an investor to use and transfer their investment since that specific market is very active. Also, it takes a much larger volume of bids and offers to move the price since there are a large number of resting orders at each price level.
On the other hand, the lower the liquidity, the harder it is and it usually implies that the investor is stuck with whatever they have invested in because of a lack of buyers and sellers. This translates to more risk because an investor may not be able to get out in time, leading to financial losses.
However, low-liquidity stocks can be manipulated much easier than stocks with high-liquidity. Since liquidity drives the pricing of a stock’s current intrinsic value, low liquidity can indicate a stock that people have not caught onto yet. The cryptocurrency bubble is a great example as more and more people have begun to buy them. Those that are investing in cryptocurrency hope that the numbers will continue to increase due to a lack in liquidity and market evaluation.
What Is the Most Liquid Asset?
Cash is considered to be the most liquid asset because of how quickly it can be converted into other assets.
In other words, there are no further steps needed to convert cash because we can spend it as it is. Ratios such as current ratio and acid test ratio are used to measure liquidity, which you can read about in our financial ratios article. Investments such as bonds and stocks can be easily transferred into cash relatively quickly.
For example, if someone loses $10,000 in Treasury bills, the money in those bills is easily accessible because the value of the bills are known.
Real Estate Isn't It
Other factors such as real estate and materialistic items are not as liquid because of the time that it takes to sell the property and finalize the details of acquiring said property. Unlike cash, a buyer or a middleman is needed in real estate which makes property very illiquid.
So if someone, whose assets were only in real estate, said they needed cash in three days, they would not be able to get the cash. It’s impossible to find a real estate agent, set a price, get a home inspection and list the property in such a short amount of time.
Trading in a Liquid Market
A liquid market has many buyers and sellers with relatively low transaction costs. It’s easy to execute a trade quickly and at a reasonable price because of the sheer numbers of buyers and sellers. For starters, it’s very easy to acquire American Airline stock (AAL) because there is a lot of it and people are constantly buying or selling.
What Is the Most Liquid Market?
That would be the forex market, where foreign currencies are traded. It also helps that the forex market operates 24/7 during Monday-Friday. The daily trading volume for the foreign currency market is worthed over $5 trillion, with the U.S dollar dominating that estimation.
The opposite of a liquid market is a thin market or illiquid market. Thin markets have large differences between what the buyer wants to buy and what the sellers will offer. This leads to inefficiency as buyers cannot find sellers and sellers cannot find buyers.
Relationship Between Liquidity and Volatility
There is an inverse relationship between liquidity and volatility as when there is low liquidity, there is high volatility and vice versa. Volatility refers to the variation of a stock’s trading price over a series of time. Due to this converse relationship, the most volatile conditions occur when an increase in volume correlates with a decrease in liquidity. So prices will fluctuate much more drastically in a more volatile market than a market with high liquidity.