In this article, We learn about “Liquidity “.Let’s Go!
Liquidity describes the extent to which an asset can be quickly bought and sold at a stable price and converted into cash.
Liquidity refers to the speed and cost of selling an asset, whether it’s a financial asset like a stock or a physical asset like a commercial building.
If a person owns an asset with a “real” or fundamental value of $100 and can immediately convert that asset into $100 of cash or cash equivalents, then we consider the market for that asset to be fully liquid.
Of course, such a perfectly liquid market is rare in the world.
Liquidity is also used to measure how quickly asset buyers convert cash into tangible assets.
So, in a perfectly liquid market, someone who wanted to buy an asset with a fundamental value of $100 would be able to buy that asset immediately for $100 and receive it immediately.
Measure how many buyers and sellers are present and whether the transaction is going smoothly.
Typically, liquidity is calculated by the volume of trades or pending trades currently on the market.
Liquidity is considered “high” when trading activity levels are high and both supply and demand for an asset are high because it is easier to find buyers or sellers.
If there are only a few market participants and transactions are infrequent, then liquidity is considered “low.” This is called an illiquid market.
Why is liquidity so important?
Market liquidity is important for many reasons, but mainly because it affects how quickly positions can be opened and closed.
Liquid markets are generally less risky because there is usually always someone willing to take the other side of a particular position.
This can attract more traders to the market, thereby increasing favorable market conditions.
In a liquid market, sellers will quickly find buyers without having to lower the price of an asset to make it more attractive. Buyers, on the other hand, don’t have to raise the price to get the asset they want.
The liquidity of an asset is also a key factor in determining the spreads offered by a trading platform or broker.
High liquidity means there are a large number of buy and sell orders in the market. This increases the likelihood that the highest price a buyer is willing to pay and the lowest price a seller is willing to accept are closer.
In other words, if the market is liquid, the bid-ask spread will tighten .
If the market lacks liquidity, the bid-ask spread will widen .
What causes insufficient liquidity?
There are two frictions that cause market liquidity to be suboptimal, or illiquidity.
The first one is Indirect costs. It may take some time for the asset to convert into $100 in cash.
For example, we may have to bring the asset to the market, or if we are on the market, we may have to wait until someone wants the asset.
This waiting time , sometimes referred to as waiting cost or search cost, is a manifestation of illiquidity, which makes the market less than perfect liquid.
The second friction is direct cost.
We may decide to pay someone to sell the asset immediately. Instead of paying the indirect cost of waiting to find someone willing to pay us the full $100 in cash, we could choose to reduce the wait time to zero and simply pay someone else (i.e., the “dealer”) to wait on us.
We are actually paying dealers for trading immediacy , or liquidity .
This cost is called Transaction Cost or Liquidity Cost. But more commonly known as the “ask-ask spread” or “spread.”
For example, we might sell an asset to a dealer for $99.00 and then have the dealer worry about waiting to find someone who wants the asset.
In this case, the dealer provides us with transaction immediacy in exchange for a $1.00 fee.
While we reduce the waiting cost to zero, this is not a case of perfect liquidity as we have to pay a fee.
While dealer is a common term for someone who provides instant (or liquidity) services for such transactions in the financial markets, principal, financial intermediary, etc. The terms and broker are also used.
In financial markets, financial institutions such as investment banks often act as traders for investors.
How to utilize liquidity in trading
When you trade the financial markets, you need to consider liquidity before opening or closing a position.
This is because a lack of liquidity is often associated with increased risk.
If the market is volatile but there are fewer buyers than sellers, it may be more difficult to close a position.
In this case, you may run the risk of falling into a loss, or you may have to go long at a different price to complete the order.
The most important thing to remember is that market liquidity is not necessarily fixed, it is dynamic, constantly moving from high to low liquidity.
Whether liquidity is currently high or low depends on a variety of factors, such as trading volume and time of day.
If you trade the market during non-trading hours, you may find that there are fewer market participants and therefore much lower liquidity.
For example, during Asian trading hours, liquidity on the Swiss Franc currency pair may be reduced. Spreads will be wider compared to European trading hours.
Forex is considered the most liquid market in the world due to its high volume and frequency of transactions.
So, in the foreign exchange market, liquidity is related to the ability of a currency pair to be bought and sold without causing a significant change in the exchange rate.
A currency pair is considered to have a high level of liquidity when it is easy to buy and sell and there is significant trading activity on the currency pair.
Despite high liquidity, pricing in the foreign exchange market is not stable.
The number of people trading major currency pairs leads to different opinions on what prices should be, resulting in daily price movements.
This is especially true when the news is digested by the market.
Major foreign exchange pairs, the currency pairs with the largest trading volume and the strongest liquidity.
This means that currency pairs such as EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD and NZD/USD have high liquidity.
In Forex trading, liquidity is important because it tends to reduce the risk of slippage, speed up order execution, and narrow the bid-ask spread.
If you want to learn more foreign exchange trading knowledge, please click: Trading Education.
