What is liquidity and how does it affect the stock market?

We explain the term that finance geeks are always on about.
What is liquidity?
September 20, 2021

Table of contents

In finance, liquidity refers to how easily an asset can be exchanged for cash.

For companies, knowing what their liquid assets are is important because they’ll generally need them to pay off any bills or debts they have.

Liquidity is a concept that’s also very important for investors. That’s because it plays a big role in what price you’ll end up paying when investing in stocks or ETFs.

How liquid are stocks?

In general, stocks listed on stock exchanges are considered to be more liquid than many other assets. 

That’s because — ordinarily — lots of people are buying and selling them, meaning it’s reasonably easy to exchange stocks for cash.

But not all stocks are created equal. For example, the majority of the stocks on the UK 100 index are liquid. These are big companies and normally people will always be looking to buy and sell shares in them.

In contrast, stocks that trade on the UK's alternative market for young or small companies will tend to be less liquid. 

That’s because fewer investors are looking to buy or sell shares in those firms.

It is also worth bearing in mind that a stock’s liquidity doesn’t stay the same. 

Events relating to a stock or affecting the whole stock market, such as a market crash, can substantially impact a stock’s liquidity. Often this effect is temporary, but sometimes it can be longer lasting and even lead to a delisting. 

How does liquidity affect stocks?

When you buy stocks, the likelihood is you are going to be dealing with a market maker. 

These are companies that quote bid and ask prices to the market. These are the prices at which they are willing to buy (bid) or sell (ask) shares in a firm.

To make a profit and protect themselves from losses, market makers quote a lower price to buy shares and a higher price to sell. The gap between these two prices is known as the bid-ask spread.

The more liquid a stock is, the tighter spread it will tend to have. That’s because market makers will be able to rapidly buy and sell and there is less risk that they’ll be left with an unwanted position in the stock. 

In contrast, a stock with low liquidity will mean market makers may not always be able to convert their holdings in that stock into cash. Consequently, the spread will normally be wider, so that the market maker can earn more cash for each sale they make and reduce the risk they’re taking on by dealing in that stock.

What does liquidity mean for investors?

Lower liquidity tends to mean that investors will get worse prices for their investment.

The opposite is also true. For example, the average bid-ask spread for Vodafone shares when writing this piece was 0.03 per cent.  

If you bought shares with such a narrow spread then you’ll hardly notice the difference in buy-sell prices. This is also beneficial for you as an investor, as a tighter spread makes it easier to sell at a profit.

Conversely, Sound Energy, a smaller market cap company, had a spread of 7 per cent. Assuming the spread remains the same, that would mean your holdings in the firm would have to increase in value by 7 per cent just for you to break even.

Low liquidity can also mean that orders simply fail, as no market makers are willing to provide a competitive quote at that moment in time. 

Sadly for investors, these potential problems aren’t going to disappear.

Liquidity, illiquidity and bid-ask spreads are part and parcel of investing in the stock market. They are important to be aware of when you invest, particularly on less liquid markets, such as the UK market for young or small companies, or stocks in companies that are in distress.

Investors who invest for the long term, with a diversified portfolio, are typically less concerned with the bid-ask spread. 

Over this time horizon, they reasonably expect that the value of their portfolio will grow, and the impact of the spread should become less important. At the other end of the extreme, day trading tends to be far more impacted, as traders very often see the gains they hoped to make eaten up by the spread.

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Important information

When you invest, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you invest.

Freetrade does not give investment advice and you are responsible for making your own investment decisions. If you are unsure about what is right for you, you should seek independent advice.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).

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