What is Liquidity?
A simple view of the stock market suggests that for every buyer there's a seller. If you own 100 shares of Coca-Cola and it's selling for $40 per share, you can make $4000 right now with the click of a mouse. Similarly, if Intel is selling for $24 a share, you can buy 100 shares for $2400 with the click of a mouse.
For a big and popular stock that's traded as much as Intel or Coca-Cola, that's more or less true. You can buy or sell at or near the current trading price. You may be off by a few cents either way, but the current price is pretty solid.
What is Liquidity?
The technical term for the market's ability to facilitate a sale at the desired price is liquidity.
You may hear this described in terms of high or low. High liquidity is when an investment is easy to turn into cash (or is cash). Low liquidity is the opposite.
In other words, the more liquid an asset, the easier it is to sell it for a price reflecting its value. For example, the liquidity is money is high because you can easily trade a dollar bill for four quarters or vice versa. A stolen Picasso or Van Gogh painting is illiquid because it's difficult to sell something so famous that everyone knows has been stolen. You'll have to reduce the price from the expected value (priceless!) to account for the fact that there just aren't that many potential buyers.
What is the Liquidity of an Investment?
Every investment has a measurable liquidity: the ease with which you can sell it. Liquidity measures both the number of buyers and sellers as well as the relative demand for the asset. An asset may have a high demand but low liquidity if buyers and sellers disagree on the value. Unless they both agree on a price, there's no transaction. Similarly, everyone may agree on the price of a thing, but there may be few buyers or sellers.
As you might expect, cash is the most liquid investment. Another example of an asset with high liquidity is your savings account. The closer an asset is to cash, the more liquid it is —money market liquidity is high, because the provider of this account lets you deposit and withdraw assets in cash with impunity. Similarly, gold and silver bullion have a high liquidity because bullion is fungible (one bar is as good as any other bar) and there's high demand for trading commodity precious metals.
Stock liquidity varies based on multiple factors—individual stock shares are fungible, but that doesn't necessarily mean they're easy to buy or sell. An important component of liquidity is the speed at which you can perform a transaction—not measuring it in terms of milliseconds but the time elapsed between when you put up the asset as a seller and when you find a buyer. In terms of stocks, a blue chip on the Dow will have a lot of buyers and sellers and finding a willing buyer or seller is relatively easy because there are so many transactions happening every day. If your transaction time is too slow, you may miss out on your price. (That's unlikely for value investors, but it's a big concern for high frequency traders and day traders.)
Contrarily, a penny stock has many fewer trades in any given time period, so you might have to wait a long time between transactions. You'll have more trouble buying at the price you want because you have to do more work to find a seller at that price and more trouble selling at the price you want (because you have to do more work to find a buyer. Worse yet, the illiquidity of an infrequently traded stock means that there's less consensus on a fair price and, consequently, any trade you make has a much greater potential to move the price of the stock dramatically.
This is one of the worst flaws of penny stocks: prices may look great and you may see what appear to be wonderful opportunities to profit, but there aren't enough shares traded for you to get the prices you want, even if you have all the transaction speed in the world.
What Does Investment Liquidity Imply?
The more liquid an investment, the more likely you can buy or sell it at the current trading price, sell it now at any price, and buy or sell as much as you want.
If you're investing regularly, you may want to keep some of your assets in very liquid form: cash, Treasury notes, money market accounts. This way, if you find a really great value opportunity, you can immediately buy it. It's frustrating to have to pass up a good investment because you can't sell another asset to free up funds (or, worse, take a loss on an investment just to get out of a position).
If you're investing in smaller companies (not necessarily microcaps, but anything outside of the S&P 500, DJIA, or Russell 2000, for example), keep in mind the trading volume of the stock. Only on special occasions (ex-dividend dates, earnings announcements, unforeseen news) will the number of trades exceed the average. Your ability to move in and out of a position at its current price will be limited by the available buyers and sellers.
Limitations of Liquidity
Low liquidity doesn't mean that you can't sell it. It means that you have, in general, more trouble selling at the current price. The more you discount the price, in general, the more liquid you make the asset. Think of it this way: you want to find good stocks at great prices. The better the price, the better the stock looks! The more buyers there can be.
The liquidity of an asset is one aspect to keep in mind while investing, yet high liquidity investments aren't always what you want. This just a way of measuring your ability to get in or out of a position. If you've found a great stock you can buy and hold forever, daily trading volume and price variance doesn't really matter.
These aren't exact measurements. The market isn't 100% rational, and there are enough automated actors in the market trying to make sure that trades get filled (and trying to make money on millisecond trades) that you can't predict the exact price for any asset. Yet as a rule of thumb, measuring the trading volume of a stock over time will give you some great hints as to your ability to buy and sell that stock at your desired price.