What is market liquidity and why it matters?

As investors, we know that when we are buying shares of a stock, ETF, or other security, we are not buying it directly from its issuer but from another investor. Vice versa, when we are selling off shares, we are essentially finding another buyer for them on the market.

In order for these transactions to take place quickly and at a stable price, the market needs to be liquid. Market liquidity is calculated by the volume of trades at any given time. If there are many transactions and lots of supply and demand for an asset, then the market is considered liquid. If it takes a long time for a buyer or a seller to find another investor to take the opposite side of their transaction, and trades are happening infrequently, this is called an illiquid or low liquidity market.

This metric is important for many reasons, but the main one is that it impacts how quickly one can open and close positions, or buy and sell shares. The reason why this matters is because the quicker the trade is completed, the better chance you have of getting the price you originally agreed upon. For example, in a liquid market, a buyer would not have to increase their offer to secure the asset they want, and respectively, a seller wouldn’t have to lower their asking price, in order to find a willing buyer.

It’s important to note that market liquidity is dynamic. One impactful factor to watch out for is the time of day. If you are trying to trade JPY currency pairs during European trading hours, you will likely notice lower liquidity, due to the smaller number of Asian market participants. This can lead to wider bid/ask spreads and a less favorable outcome. In this case, you might consider waiting until Asian trading hours to initiate your transaction and avoid compromising on price, because of lower market liquidity.