A:

Liquidity refers to how easy it is to buy and sell shares without seeing a change in price. If, for example, you bought stock ABC at $10 and sold it immediately at $10, then the market for that particular stock would be perfectly liquid. If instead you were unable to sell it at all, the market would be perfectly illiquid. Both of these situations rarely occur, so we generally find the market for a particular stock somewhere in between these two extremes.

The bid-ask spread and volume of a particular stock are closely interlinked and play a significant role in the liquidity. The bid is the highest price investors are willing to pay for a stock, while the ask is the lowest price at which investors are willing to sell a stock. Because these two prices must meet in order for a transaction to occur, consistently large bid-ask spreads imply a low volume for the stock while consistently small bid-ask spreads imply high volume.

For example, a bid of $10 and an ask of $11 for stock ABC is a fairly large spread, meaning the buyer and seller are far apart. No transactions can take place until the buyer and seller agree on price. Should this large bid-ask spread continue, few transactions would occur and volume levels would be low, implying poor liquidity: either the bid or ask price (or both) would have to move for a transaction to take place. On the other hand, a bid of $10 and an ask of $10.05 for stock ABC would imply that the buyer and seller are very close to agreeing on a price. As a result, the transaction is likely to occur sooner and, if these prices continued, the liquidity for stock ABC would be high.

However, liquidity is more of a qualitative measure, meaning there is no one quantity of stock volume that can tell us how liquid an investment is.

(For more on the bid-ask spread, read our article Why the Bid/Ask Spread Is So Important.)

RELATED FAQS
  1. What types of stocks have a small difference between bid and ask prices?

    Learn more about bid-ask spreads and why stocks with high levels of liquidity and low levels of volatility usually have narrow ... Read Answer >>
  2. What are the determinants of a stock's bid-ask spread?

    Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask prices. The bid price is the ... Read Answer >>
  3. How do I use the bid-ask spread to evaluate whether I should buy a particular stock?

    Understand the significance of the bid-ask spread for investors in making a decision on whether or not to purchase a particular ... Read Answer >>
  4. What does the variance between the bid and ask price of a stock mean?

    Find out how stocks are traded in the market, why the bid and ask prices are different and why the bid-ask spread is smallest ... Read Answer >>
  5. How do I use a limit order in conjunction with a bid-ask spread?

    Understand the concept of the bid-ask spread as it applies to trading and how it impacts the pricing of limit orders used ... Read Answer >>
Related Articles
  1. Investing

    Understanding Liquidity Risk

    Learn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
  2. Investing

    What Does Bid And Asked Mean?

    Bid and asked is a two-way price quotation.
  3. Investing

    Penny Stocks

    Learn more about this cheap stock and how its high risk nature, large bid-ask spreads and lack of liquidity may not make it the most wise investment.
  4. Trading

    The Basics Of The Bid-Ask Spread

    The bid-ask spread is essentially a negotiation in progress. To be successful, traders must be willing to take a stand and walk away in the bid-ask process through limit orders.
  5. Insights

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  6. Investing

    Is a Stock's Trade Volume Important?

    Stock volume is easy to calculate but understanding its importance is a little more involved. Take the time because it's a worthwhile investing tool.
  7. Investing

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  8. Investing

    What is Spread?

    Spread has several slightly different meanings depending on the context. Generally, spread refers to the difference between two comparable measures.
RELATED TERMS
  1. Bid-Ask Spread

    The amount by which the ask price exceeds the bid. This is essentially ...
  2. Dollar Volume Liquidity

    A stock or exchange-traded fund's share price times its average ...
  3. Price Continuity

    A characteristic of a liquid market where the price movements ...
  4. Price Tension

    The phenomenon by which the seller of a particular good, service ...
  5. Ask

    The price a seller is willing to accept for a security, also ...
  6. Liquidity Risk

    The risk stemming from the lack of marketability of an investment ...
Hot Definitions
  1. Price Elasticity Of Demand

    A measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. Price ...
  2. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  3. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center