Liquidity refers to the tradability of any investment security. It means how quickly something can be bought or sold to other willing buyers or sellers. Different investment options have different liquidity. Stocks are highly liquid because they can be bought or sold very quickly from the stock market. On the other hand, real estate is not liquid because it takes weeks or even months to buy or sell a property.
Is high liquidity good?
High liquidity of an investment security is considered to be great for investors because it allows them to exit their investment to reap the reward whenever they want. Almost everyone has either faced problems or knows somebody who has faced problems selling a house. It can take weeks (or even months) to sell off a property! This makes real estate a bad investment when you are in dire need of money because the liquidation process is very time consuming. On the other hand, stocks offer high liquidity which is great especially in the time of emergencies because they can be exchanged easily for money.
Do different stocks have different liquidity?
Yes, different stocks have different liquidity. Consider a stock such as Reliance Industries which is the biggest company in India and is the highest weightage in the Nifty index. This stock is highly liquid because there are willing buyers and sellers available every single second during the trading day. Almost all large caps are highly liquid stocks due to high demand amongst investors. On the other hand, there are illiquid stocks such as Frontier Springs which is a microcap company. This stock doesn’t trade as freely during a trading day which can make it difficult for buyers or sellers to get in or out of the stock.
One important parameter which can be used to check the liquidity of the stock is volume. Volume refers to the total number of stocks which have exchanged hands in a particular time frame. Volume is often used by technical analysts for stock trading. To learn more about the importance of volume in stock trading, visit this article! A stock which has good volume throughout the day is generally a stock which has high liquidity. Let’s consider Reliance Industries.
The volume of shares which have traded in the last hour is 529k (5.29 Lakhs). This is a sign that the stock is highly liquid! Now, let’s consider Frontier Springs.
The volume of shares which have traded in the last hour is only 1000. This shows that the stock is highly illiquid and has fewer buyers and sellers.
Does liquidity affect price fluctuations?
A highly liquid stock has typically a much smoother price fluctuation as compared to less liquid stocks. This has entirely to do with how stock prices actually move. Unlike popular opinion, the stock price moves simply based on supply and demand, not the fundamentals of the company even though the price typically aligns with the company fundamentals over the long term. To learn more about how stock price moves and why it doesn’t move based on fundamentals of the company, visit this article!
A highly liquid stock has thousands, if not lakhs of people who want to trade the stock which means that it is really easy to sell your stock at the market price. If you sell 100 Reliance shares at CMP (current market price), you will almost always be able to get 100 times the CMP by selling your stocks. However, that is not how less liquid stocks work. If you sell less liquid stocks at the CMP, there is a very high possibility that a lot of those stocks will be sold at a much lower price than the CMP because of lack of buyers. Suppose you want to sell 500 quantity of your less liquid stock at Rs. 100. If the buyers selling near CMP are selling only 200 shares, then the remaining 300 shares will be sold to whoever is buying at the next highest price. If the next highest buyer is offering only Rs. 90 (instead of CMP = Rs. 100), then the remaining 300 shares will be sold for Rs. 90 each! Less liquidity means it becomes much harder to exit your investment because there aren’t enough people interested in buying the stock. This issue of less liquidity is observed with smaller, unknown companies.
Should retail investors stay away from low liquidity stocks?
No, retail investors should not stay away from a stock simply because it has low liquidity. Investors buying the shares based on fundamental analysis are looking for the long term reward by investing in the company. The issue of lower liquidity is much less of a concern for an investor due to the long time horizon of the investment as long as the company has a sound business model. However, an investor must be cautious of over-exposing themselves to low liquidity stocks because the exit from the stock can prove to be difficult especially in a market crash scenario. A highly liquid stock is always preferred over a less liquid stock, everything else considered equal.
Should retail traders stay away from low liquidity stocks?
Yes, retail traders should absolutely stay away from a stock because of its low liquidity. The whole idea behind stock trading is buying and selling stocks in the short term to make a quick profit. A stock which has low liquidity defeats the entire purpose of trading because such stocks do not provide a smooth exit from the trade. Imagine being unable to sell up on hitting your target just because there are no other buyers for the stock! High volatility and highly liquid stocks are always the preferred choice for stock traders.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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