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Posted by Deborah Beckwin - 23 August, 2019

The Difference Between Liquid and Illiquid Markets

Buying and selling popular stocks on an exchange such as the Nasdaq or NYSE can be as simple as they come. Pick a stock, put in an order, and you'll often get filled right near the current price, assuming there is low volatility.

But get out of the mainstream stocks and you'll find a whole different type of trading. Bid/ask spreads are wide, trading volume seems absent, it's difficult to get your order filled at a reasonable price either through buying or selling. This means you might have to sell your stock at an unfavorable price if you're trying to get out. What is the issue? In a word - illiquidity. In this article, we look at the differences between liquid and illiquid markets.

Liquid Vs. Illiquid Market?

A liquid market has plenty of buyers and sellers. In such a market, it's easy to get filled at a reasonable price. Meaning, something near the current price the stock is trading at. Futures equity markets are generally known for their great volume. For example, the S&P 500 emini futures can handle trades of only a few contracts up to much larger orders. All of this because there are plenty of buyers and sellers.

Any market that doesn't have immediate price discovery, volume, or wide bid/ask spreads is an illiquid market. Basically, an illiquid market is the absence of liquid assets. Buyers and sellers are few and far between in these markets.

cash is the most liquid asset(source)

An illiquid market doesn't mean you can't buy and sell in those markets. In fact, you can be successful trading in illiquid markets. It does take some planning, though.

Transacting In A liquid Market

As mentioned above, transacting in a liquid market is fairly straight forward and presents few, if any, problems. An illiquid market is a different animal altogether.

One of the first issues you'll run into when trying to trade in an illiquid market is a wide bid/ask spread. When you buy a stock, you get the asking price. When you sell a stock, you get the bid price. The difference between these two prices is called the bid/ask spread. When there are many buyers and sellers, creating lots of volume in a stock, the bid/ask spread shrinks.

As an example, say you want to buy ABC stock at $101.20. It's bid/ask is 101.18 x 101.21. That's a small bid/ask spread, indicating there's a lot of trading in ABC. In other words, it's a liquid market. While you may not get 101.20, you should have no problem getting 101.18.

Consider the flip side with XYZ at 101.20 and a bid/ask of 101.00 x 101.35. That's a much larger spread, indicating an illiquid market. Putting in an order for 101.20 has virtually zero chance of being filled. You'd more likely need to place the order at 101.05 or even 101. Not really ideal. For some stocks, spreads can be even much larger. 

To succeed in such a market means being fine with an entry at 101 rather than 101.20. Meaning, you have to work with the bid/ask that's available and be comfortable trading that particular market.

What Are Some Examples Of Illiquid Markets?

Besides the financial markets mentioned above, a few other good examples of illiquid markets include real estate and private equity. Think about when you bought your home. It was not a quick transaction and there was probably a lot of negotiating on the price.

cash flow(source)

In an illiquid market, you can negotiate on the price. In a liquid market, because there are so many buyers and sellers available, the market is efficient - quickly matching buyers and sellers. There is no room for negotiation in a liquid market. If a buyer tries to negotiate, there are 10 sellers waiting to buy at the asking price. The negotiator doesn't stand a chance.

Back to buying or selling a home, there might be only one buyer or seller for a particular home. So price discovery must occur. Price discovery is the process of determining where the buyer and seller meet. Once the buyer and seller come to an agreement, the market price of the home has been discovered. 

In an illiquid market, the discovery of one asset can have a cascading effect on the value of similar assets. Let's say the homes in a neighborhood are valued at $275,000 on average. Then one day, a home in that neighborhood sells for $200,000. The prices of similar homes are likely to come down, even though they are not for sale.

In private equity, where investors put money into private companies, price discover often happens through these equity rounds. The first round of investments may value a company at $10 million. The next round requires more capital, which increases the company's value to $20 million. Then one day, the company decides to do an IPO, which jumps the value to $50 million.

Once the company goes public, investors get to see what the company is actually valued at. This is because the company's stock will begin trading in a very liquid market - the stock market. Private equity investors could be right or wrong with their valuations but everyone will find out once the stock begins trading.

Illiquid markets can be intimidating. Transactions can be slow and market prices can be difficult to find. For patient investors with detailed knowledge about specific markets, illiquid markets can produce great opportunities through the buying of undervalued assets. In contrast, Liquid markets mean buying an asset at fair value with the ability to quickly sell it at a market price.

Summary

  • A liquid market has plenty of buyers and sellers. In such a market, it's easy to get filled at a reasonable price
  • Any market that doesn't have immediate price discovery, volume, or wide bid/ask spreads is an illiquid market
  • Illiquid can be difficult when there are many buyers and sellers
  • Buying in these markets have positive and negatives on both sides

Control your company's cash flow

Topics: Finance, Liquidity, Stocks

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