What is Liquidity in Trading?

Every trader who plans to trade securities on the stock market or OTC Forex instruments needs to understand what liquidity means. After all, a proper understanding of the concept of liquidity can help you choose more promising assets in terms of potential profitability, and thus increase your income.

This article discusses why liquidity is so important and what factors influence it. We will also tell you which formulas can be used to calculate various liquidity ratios and how to apply them in practice. We have also compiled tables of the most liquid assets in different markets so that you do not have to search for this information on your own.

What is liquidity?

The term "liquidity" refers to any asset that can be sold or bought. Highly liquid and illiquid can be shares, currency pairs, cash, real estate, etc. Broadly speaking, liquidity is the property of an asset to be bought or sold quickly at a price that is close to its market value. Thus, the quicker you can get money for that asset, the more liquid it is. The most liquid asset in the world of trading is cash because its face value remains unchanged and it can be easily and quickly converted into other assets.

Assessing liquidity can be very helpful when making investment decisions because the outcome of your trades depends directly on which assets you are trading (liquid or illiquid). By identifying the liquidity of a particular asset you will also be able to determine how quickly you can make money trading it.

Why is liquidity important when trading financial instruments?

There are several important reasons why liquidity should be assessed when trading securities and OTC assets. It is the liquidity that determines how quickly an investor can buy or sell a particular financial instrument without losing value. The liquid market is often considered to be less risky because in this case, a trader may find a buyer for it quickly without losing the price. If the investor, on the contrary, buys the asset, then the chance of getting it at an undervalued price also increases significantly.

However, when buying and selling assets, it should be borne in mind that market liquidity ratios are not fixed. The liquidity of securities and Forex instruments depends on many factors, including the volume and time of trading. For example, liquidity in currency pairs (including the pound sterling) is reduced during Asian trading hours. It follows that to achieve your investment and financial objectives as quickly as possible, you should always consider the liquidity of the particular asset at the time.

How to measure liquidity?

In economics, liquidity is not an abstract concept. Special formulas allow you to calculate various liquidity ratios, which can then be applied to trading. In the following, we will provide you with the most common formulas for determining liquidity levels and also show you how to derive specific values using examples.

Current Liquidity Ratio

The current ratio (also known as the working capital ratio) is a measure of a company's ability to pay its debts with its existing assets. It is the easiest figure to calculate and even a novice trader can manage it. This is the formula you can use to do it: 

Current ratio = current assets of the company / current liabilities of the company

What is liquidity in the Forex Market?

The term "liquidity" applies to both the stock market and the forex market. Only in the latter case, liquidity illustrates the ability of any currency pair to be sold or bought at a price close to the market price. However, not all currency pairs are highly liquid. Those are the pairs that are traded most frequently, and the most highly liquid of them is EUR/USD. Thus, the liquidity of major pairs is much higher than that of secondary pairs. Moreover, the liquidity of currency pairs varies depending on the time of day.

Below you can see the average daily turnover of the major currency pairs:

• EUR/USD: average daily turnover is 1.173 trillion USD.
• USD/JPY: average daily turnover is $902 billion.
• GBP/USD: average daily turnover is USD 470 billion. 
• USD/CHF: Average daily turnover - USD 409 billion. 
• USD/CAD: Average daily turnover - USD 275 billion.
• AUD/USD: average daily turnover - USD 249 billion.
• NZD/USD: average daily turnover - USD 229 billion.

Example

GBP/USD is one of the most traded currency pairs on the Forex market with an average daily turnover of approximately $470 billion. This currency pair is highly liquid but less popular than USD/JPY and EUR/USD. The most popular currency pair is EUR/USD, as its daily turnover exceeds USD 1 trillion.

Factors affecting market liquidity

The liquidity of any financial instrument is affected by a huge number of factors such as interest rates, current prices, central bank rules and regulations, number of assets in circulation, etc. Liquidity also depends on the class of asset. For example, real estate is much less liquid compared to equities. In addition, the liquidity of some assets, such as commodities and derivatives, usually depends on the volume of trading and the number of exchanges on which they are traded. 

Generally, there is a pattern between liquidity and the type of exchange used for trading. Generally, the most liquid assets are those traded on popular and large exchanges. While instruments traded on less developed or smaller markets are illiquid.

Another factor that affects liquidity is the time of day you choose to trade. For example, you will get the best selling or buying prices of currency pairs involving the Euro during the official business hours of all European exchanges. But the liquidity of the same pairs during Asian session hours will be much less. 

Here is another example of comparing the liquidity of different assets. Let us compare the liquidity of Google shares and Tesla Motors. For example, on October 9, 2020, Google stock had a total trading volume of $1.3 million. These numbers are huge, so this company's securities are highly liquid. But if you compare them to the performance of Tesla Motors, which had a total trading volume of $42 million that day, it immediately becomes clear that Google stock showed less liquidity than Tesla Motors stock that day.

We do not recommend that you trade securities of companies whose daily trading volume is in the double or triple digits as they are often considered illiquid. 

You must pay attention to liquidity while trading regardless if you are a beginner or a professional trader.