Nicole Wachs explores why liquidity is important and what happens when it dries up.

In my last post Is short selling bad for the market? I explained one of the positives short sellers bring to the table is adding liquidity to the market. Pretzel, a member of our Trader Network, wasn’t entirely convinced. Pretzel’s questions give me a chance to further explain the importance liquidity plays in our financial system. I will also follow up with an explanation of the effects of declining or low liquidity. When you understand the implications, it may be easier to see that liquidity is paramount to a healthy market.

To keep the discussion focused on stock and options market liquidity, I will not include any mention of liquidity in the credit markets.

Why is liquidity important?
Here’s an analogy for you: Liquidity is like the blood that pumps through the market. If there is less of it, problems will arise. If more blood is added, that helps things move through the market more smoothly. Whether or not someone owned something before it was sold has no bearing on whether it brings liquidity to the market. Short sellers are a group of market participants. If you remove this group from trading in the markets, you have fewer participants, which usually means less shares are trading, and all this leads to less liquidity.

The ill effects of illiquidity – less activity leads to less activity
When liquidity decreases, a number of things happen. First the number of shares traded (or number of contracts) declines. Many traders will only trade securities that reach a minimum threshold for volume, so if volume is declining from fewer participants, it may continue to decline since more participants may stand on the sidelines. This further reduces liquidity.

New products face this problem, but in reverse. New products are low on volume and traders will not join in until volume increases, but if no one starts trading, volume can never increase. The old catch-22!

…and wider spreads
Another thing that happens as liquidity declines is the bid-ask spread widens. Tighter spreads are always better, in this case.

The bid represents the highest price someone is willing to spend when buying. The ask (or offer) is the lowest price someone is willing to receive when selling. These two prices create the market quote, and the difference between them is called the spread. Investors always prefer a tight spread because it affects the net result of any position they hold.

Without getting into a discussion about limit orders, etc. let’s take this example. If you want to buy, you must pay the ask price. When you are ready to sell, you look towards the bid price. The wider these prices are from each other, the more it cuts into your net profit, or increases your net loss, whichever the case may be.

Wide spreads often occur when there is news out on a company, but the market does not yet know how to interpret it. If people are holding there money back from trading, reducing liquidity, the spread widens. Through price discovery and the return of participants, the spread usually narrows.

…which both lead to choppy markets
Finally, securities with low volume and/or wide spreads often have prints (prior trades) that are “choppy” or “gappy.” Often referred to “price swings”, this is when the price of one trade varies greatly from the previous one. This can happen on occasion with liquid securities too, but is more common with illiquid ones.

Holding a position in one of these choppy monsters is no fun. You never feel at ease because you never truly know where the market is. Uncertainty is not a good thing when it comes to the financial markets.

All of these factors stemming from illiquidity lead to a market condition I like to call a Roach Motel. You can check in (enter a position) but you can’t check out (exit a position).

As always thanks for the comments and keep them coming!


Regards,
--Nicole Wachs
Director of Education
All-Star Commentator

Nicole’s previous blog posts: Is short selling bad for the market? and Short Interest and Days to Cover

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