Why Liquidity is Important

Liquidity in the financial markets refers to how easily a given financial instrument can be sold, and is a reflection of the number(s) of people involved in buying and selling the instrument.  Whether it is stock, options, futures, ETFs, forex, etc, trading and investing in the financial markets involves buying and selling.  When there are many people buying and selling, we say that there is much liquidity for the given instrument, and when there are few folk buying and selling, there is low liquidity for the instrument.  If newbie traders are to remain ‘viable’ in the trading arena, they must learn to only ‘play’ in liquid markets.  Liquidity allows newbies to reverse out of a trade quickly and at a minimal loss if they decide that they made a mistake, and do not wish to be in a trade.

Here’s why …

The more liquid the instrument, the ‘tighter’ the bid-ask spread – and, the less we lose immediately. 

In brief, the bid-ask spread is the difference between what we buy an instrument (stock, future, etc) at, and can sell it at if we decide that we immediately want to do so. The wider the bid-ask spread the more we lose immediately when we buy anything.  Explained another way, the bid-ask spread represents the minimum we must make (the instrument must gain) for us to ‘break even’ (get our money back).

The tables below shows the effect of a 10, 15 & 20 cent bid-ask spreads and the effect of a 5, 3, & 1 cent bid-ask spreads on $1, 2, & 3 options.

The Effect of Bid-Ask Spreads

How Large Bid-Ask Spreads Lead to an Instant Loss

As illustrated in the table above, a 1 cent spread is only 1% of a $1/= option; a 5 cent spread is 5% of a $1/= option, which would result in an immediate 5% loss if the option is sold immediately.  In practical terms, what this means is that the first 5% move in the ‘right direction’ is only getting one back to ‘break-even’ (not accounting for commissions).  With ‘tighter’ the bid-ask spreads, the stock (future, etc) has to move only minimally to start making money, and result in a profitable trade.

In essence, the ‘tighter’ the bid-ask spread, the less your stock (future, etc) has to move to start making money to result in a profitable trade.

In closing, learning the importance of liquidity in the financial markets is vital, and how to find optionable stocks with highly liquid options is extremely important for newbie traders to learn early in their trading career.

See Liquid Stocks and ETFs for a list of liquid stocks & ETFs with highly liquid options.

Happy Trading!