What is Liquidity in Stocks and Financial Instruments?
Liquidity is your ability to buy or sell a stock on any given day at any given price. This affects your investments--and the money you can make.
In the most simple terms, there's always a buyer for every 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 in a snap.
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 price of a stock is rarely a surprise.
What is Liquidity?
Investors and financial folks have a technical term to describe the ease of buying or selling a security. Liquidity is the market's ability to facilitate a sale at the desired price.
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 due to the risk.
Investors may also talk of high liquidity and low liquidity. High liquidity describes something that's easy to turn into cash (a savings account, an individual share of publicly traded stock from a big company). Low liquidity describes something that's harder to buy or sell, often due to a low number of buyers or sellers or the difficulty of getting the desired price (real estate, a stolen Picasso, seventeen thousand tons of expiring pork bellies).
Every Investment Has Liquidity, But How Much?
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. Without agreeing 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. (The term "liquid cash" is a tautology.) Your savings account is also highly liquid. 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. Gold and silver bullion have relatively 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 they might not be easy to buy or sell. Liquidity also has a time component; how much time elapses between the seller offering the asset and the buyer accepting? 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. (High frequency/day traders run this risk; value investors often do not.)
Surprisingly, a penny stock is rarely liquid. 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 suggests that buyers and sellers may not agree on a fair price. As a consequence, 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. Getting into a position may be difficult. Getting out could be even worse.
How to Think about the Liquidity of Your Investments
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).
To put it more bluntly: your flexibility as a value investor depends on your ability to take advantage of great opportunities. If a good opportunity gets in the way of a great opportunity, you may end up kicking yourself. Don't take this too far; a good investment you can hold onto is a good investment. Yet also be patient and don't jump on the first investment that might be good because you feel like you must invest everything right now.
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.
Liquidity is Important, but It's Not Everything
Low liquidity doesn't mean that you can't sell an investment. It means that you have more trouble selling at the current price. The more you discount the price, the more liquid you make the asset, generally. 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.
High liquidity is great when selling, but liquidity isn't the only good attribute of an asset. This just a way of measuring your ability to get in or out of a position. These measurements aren't exact, because the market isn't 100% rational. The market moves fast enough that pinning down any exact price may be impossible.
Even so, as a rule of thumb, measuring the trading volume of a stock over time will hint at your ability to buy and sell that stock at your desired price. Remember, this matters only when you trade. If you've found a great stock you can buy and hold forever, daily trading volume and price variance doesn't really matter. Just keep owning your great stock!