To make transactions in the stock or foreign exchange market
To make transactions in the stock or foreign exchange market, you need to know which exchange instruments can be bought quickly and sold as quickly. Such assets are called liquid. What is market liquidity? Liquidity is the ability of material resources to be sold at a price close to a market price and the degree of liquidity reflects the time required for such circulation. This concept is applicable to different categories - assets, balance, banks and enterprises.
Depending on the time that it will take to convert assets into cash, there can be of three types of liquidity:
- Highly liquid are, for example, deposits in the bank, shares, bonds, currency or government securities. These assets can be encashed as soon as possible.
- An average degree of liquidity includes accounts receivable, other than short-term and uncollectible, as well as products ready for sale. These positions are converted into money in a period of 1 to 6 months without a significant loss in value.
- Low-liquid assets are obsolete machines and equipment, overdue accounts receivable, real estate. This includes all other categories that can be sold at a price close to the market price but it takes a long time.
Naturally, the same financial instrument can have both high and low liquidity. An oil company' shares can leave the market in a matter of seconds with a purchase price difference of a few hundredths of a percent. A stock of a little-known firm might stay on the market without being sold for much longer or, in the end, lose from the original value by 30%. Similarly, elite house in the suburbs belongs to low-liquid assets due to its features: high price, the need for personal transport, a narrow circle of buyers. But a two-room apartment in a residential area of a large city can be sold in a short time due to a large demand.
Every day, brokers add new instruments for trading and not all of them are as liquid as (in case of Forex) the euro/dollar currency pair. Having opened a trade on such a currency pair you might sit and wait for more than one day and eventually pay a huge swap, which can even cut the planned profit. Or, say, if the position closed with the stop loss due to strong volatility, it might not be worthwhile to open more positions on this instrument in such an uncertain market at the day.
The indicator of liquidity is the volume of trades. The more transactions there are with a particular asset, the higher its liquidity. The daily volume of trading on the Forex market is 3 trillion US dollars, which greatly exceeds the volume of the world stock market. Therefore, this market has the highest liquidity. In the stock market, the so-called "blue chips" - the shares of the most popular issuers - have the greatest liquidity. On the commodity markets, real estate, precious metals and vehicles have mostly high liquidity.
The risk of market liquidity is one of the main types of financial risks, which you must pay attention to when making an investment decision. At the same time, it remains one of the least formalized and the changing market environment requires constant adjustments to the assessment of this risk. What is meant by the risk of market liquidity is the ability to sell the asset for a given time with little financial loss. Basically, liquidity is assessed only at a qualitative level on the basis of market participants' expert assessments. The subjectivity of estimates, the growth in the number of tradable assets, the high volatility of financial markets leads to a low quality of liquidity risk assessment, which does not contribute to effective investment decisions.