Market liquidity is one of the most important investment factors to consider. How liquid or illiquid a market is will impact many of the investment decisions you make. Let’s take a look at why liquidity matters so much.
1. Liquidity determines how quickly prices move between trades over time. In a market that moves rapidly, the liquidity is referred to as illiquid. Prices fluctuate quickly, making it difficult to stay on top of the market, and buy and sell assets at the right time. If you are an experienced investor, investing in an illiquid market may not negatively impact you too much, but for the newbie’s, or those that are still figuring things out, this can result in mistakes that cost a lot of money.
2. Liquidity affects your trading strategies. Everyone adopts a trading strategy for how they are going to approach a market. In the Forex market, you may decide to go long, or maybe you decide to go short. Your trading strategy often depends on your experience, risk tolerance, etc. however, liquidity plays a role. In a market that is liquid, you can have a little more leeway with your trading strategy then in a thin market.
3. Liquidity impacts how profitable you can be, and how well you do overall. Illiquidity can be very damaging to an investor, making it difficult to buy or sell an asset, and often results in rapid price movements, lost opportunities, etc. Thus, the more liquid a market is, the better chance you have of making money with your investments.
4. Higher liquid markets are easier to learn in, and make up for some mistakes. Because there are larger trading volumes, and more minor price changes, a bad trade will not affect you nearly as much as a bad trade in an illiquid market, giving you room to learn without ruining yourself.
It is important to understand that the volume of the market is going to affect liquidity. The highest liquid market is the Forex market, which sees large trading volumes and minor price changes. When a large trade occurs in the Forex market, it is often just a blip on the radar, where as in the stock market, a large exchange or trade could cause major price fluctuations. Think about it this way, a ten thousand dollar deposit into the account on an average Joe can be huge, and make a large difference in their life, but that same ten thousand dollars in Bill Gates’ account or Donald Trump’s makes far less impact. This is what trades are like in high volume versus lower volume markets, and how they effect liquidity.
Liquidity is not set, no matter what market you choose to trade in, it will fluctuate during the day. Typically the higher trading volumes occur when the market opens and in the morning, and lower volumes occur when it is about to close.
Understanding liquidity and how it is going to impact your investing will make you a smarter investor and a more calculated risk taker. Take time to study the market liquidity so that you can improve your chances of investment success.