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What is Stock Liquidity ? {Infographic}

By May 2, 2018Infographic

What Is Stock Liquidity ?

Getting stuck with a stock that can’t be sold is every trader’s nightmare. Liquidity is how easily you can get into and out of a stock. A stock is said to be liquid if the shares can be rapidly sold whenever the holder chooses to and the act of selling has little impact on the stock’s price.

Liquidity is one of the indicators of a business’s health.

For a day trader, liquidity is important, both in formulating strategy and executing stop-loss orders.

For investors who want to buy and hold, liquidity is much less important.

When the stock is liquid and there is a lot of volatility, use Level II quotes to understand how the stock reacts to the previous closing price. Level 2 stock quotes show the full order book for a given stock in a ranked list of the best bid and ask prices from each of the market participants.  It gives you a detailed insight into the price action, including the market depth. Knowing exactly who has an interest in a stock can be extremely useful.

How to evaluate liquidity of a stock?

Bid-ask spread

The bid is the highest price investors are willing to pay for a stock. Ask is the lowest price at which investors are willing to sell a stock. When bid and ask matches a transaction occurs.

When there is a large bid-ask spread, very few transactions will occur and volume levels would be low, implying poor liquidity.

In the case of a small bid-ask spread, the transaction is likely to occur sooner and the liquidity of the stock would be high.

Volume

Daily trade volume is the number of shares being traded each day. If you want to find out how many buyers and sellers are involved in a stock, divide the total trading volume by two. For every trade that’s executed there has to be one buyer for every seller. The higher the number of people involved, the higher the liquidity. Daily averages are shown for the previous 10 days and three months.

Look at volume in terms of your position relative to the company’s volume. If you get into a stock for more than 10% of its daily trade volume, it gets much harder to get out of the position quickly.

 

Float

This is the number of publicly owned shares that are available for trading. This has to be seen in conjunction with daily trading volume. High float and low trading volume mean the stock is illiquid.

Trading Tips

  1. Get involved in stocks that trade a minimum of 100,000 shares a day. Any less than that will leave you worried about its liquidity, even if they have great stories.
  2. Trade stocks that can maintain 1 million or more shares in trading volume over multiple days.
  3. Use the filters in your trading software to locate stocks that have been up multiple days with building or maintained high volume.
  4. The key to penny stocking, for sure, is being able to quickly move in and out of a position, so you should only ever trade stocks that are extremely liquid relative to the capital you trade with.
  5. Don’t take too large of a position in a stock. Otherwise, it’s going to be hard to find other buyers to get you out of your shares when you need to. Take smaller positions to limit the risk.
  6. The initial hour of trading at market opening and the last hour’s trading before market close are considered to be the most liquid. If you are able to identify stocks with strong momentum, it is better to buy the stock at the market close and hold the position overnight. The next day, you close your position right at the market open, when the liquidity is at a high point.

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