What Is a Liquid Market?
A liquid market a one with many available buyers and sellers and comparatively low transaction costs. The details of what makes a market liquid may vary depending on the asset being exchanged. In a liquid market, it is easy to execute a trade quickly and at a desirable price because there are numerous buyers and sellers and the product being exchanged is standardized and in high demand. In a liquid market despite daily changes in supply and demand the spread between what the buyer wants to pay and what sellers will offer remains relatively small.
The opposite of a liquid market is called a "thin market" or an "illiquid market." Thin markets may have considerably large spreads between the highest available buyer and the lowest available seller.
- Liquid markets have many available buyers and sellers where prices change in comparatively small increments.
- Liquid markets make it quick and efficient for buyers and sellers to trade in and out of securities with tight spreads and low transaction costs.
- Liquid markets include the money market, the market for Treasuries, and many stocks and bonds.
- Markets for trading specialized physical goods such as luxury items or houses are not liquid.
Understanding Liquid Markets
Liquid markets are usually found in financial assets such as forex, futures, bonds, and stocks. Markets for high-priced tangible goods, such as luxury items, heavy industrial equipment, or houses are considered illiquid markets. But even financial securities can also be thinly traded depending on a number of factors including the time of day, the immediate conditions of a given market, or the relative visibility of the asset.
The market for the stock of a Fortune 500 company would be considered a liquid market, but the market for a family-owned restaurant would not. The largest and most liquid market in the world is the forex market, where foreign currencies are traded. It is estimated that the daily trading volume in the currency market is over $5 trillion, which is dominated by the U.S. dollar. The markets for the euro, yen, pound, franc, and Canadian dollar are also highly liquid.
Futures markets that trade on the major currencies and major stock market indexes are very liquid, but futures markets that trade specialized grain or metals products may be much more thinly traded.
Advantages of a Liquid Market
The main advantage of a liquid market is that investments can be easily transferred into cash at a good rate and in a timely fashion. For example, if someone owns $100,000 in U.S. Treasury bills and loses their job, the money in these Treasuries is easily accessible, and the value is known because it is a liquid market.
However, on the other hand, real estate property is not so liquid. Because there may be a small number of buyers for a given house in a given timeframe, it may take longer to sell the property. The faster you need to sell it, the lower the offer you will need to make to sell, which means you will receive less money you get for it.
Liquidity and Volatility
One significant factor related to liquidity is volatility. Low liquidity, a thinly-traded market, can generate high volatility when supply or demand changes rapidly; conversely, sustained high volatility could drive some investors away from a particular market. Whether it be correlation or causation, a market that has less liquidity is likely to become more volatile. With less interest, any shift in prices is exasperated as participants have to cross wider spreads, which in turn shifts prices further. Good examples are lightly traded commodity markets such as grains, corn, and wheat futures.