Liquidity

Factors include: Total shares outstanding, trading volume, average trade size, big block trade momentum, cash flow in or out. These factors will be impacted by the general level of liquidity in the market for the specific item.

Volume is a key indicator of current liquidity. Pricing may be relatively fair or unfair depending upon recent and current volumes.

Are shares broadly available for short sellers to borrow?

What is the psychology and derived interest? These will determine the level of interest and translates directly into the number of investors and speculators and their trading volume. That provides liquidity.

Good Liquidity (liquid) means:

1.) Fair prices, 2.) Narrow spreads, 3.) Easy entry and exit.

Bad Liquidity (illiquid) means:

1.) Large price moves, 2.) Wide spreads, 3.) Difficult entry and exit.

Be Wary of Illiquid Markets

Markets function best when they are liquid. When no one trader, speculator, investor, nor group has the power to influence prices or supply. Volume is a good indicator of potential liquidity. Liquidity is derived from, and proportional to volume.

Markets are kept liquid by specialists and market makers. These variously named jobs all serve similar functions. They stand ready by job-defined obligation and formal exchange rules to step in when market liquidity is low. They are required to sell (thus providing supply) and to buy (thus providing funds) when outside market participants are not willing to sell or buy. This function maintains an orderly market when illiquidity threatens to cause serious price and/or supply inequities.

Outside market participants may not be willing to participate if one or more of the following conditions exist:

1.) Prices are too low or high;

2.) Market conditions create uncertainty;

3.) Overall market volume is relatively low.

It is during periods of illiquidity that specialists and market makers are required to maintain liquidity. These requirements vary by exchange. It is difficult for the exchanges and the SEC to measure and enforce the performance of the maintainers of liquidity. At best check-up and enforcement is only possible after the illiquidity problem has passed.

Market participants should remember that the individuals and firms whose role it is to maintain liquid markets have large amounts of capital at risk and are in business to make a profit. In severe market conditions there may not be an individual or firm (that is, specialist and market maker) willing or financially able to step in with enough buying power or supply to maintain an orderly, liquid market. At these inflection points individual participants may:

A.) See prices change very fast;

B.) Be unable to buy at a relatively reasonable price;

C.) Be unable to sell at a relatively reasonable price.

Remember 1987, 1929, and other events where liquidity vanished.

See also: Efficiency

The investment axiom that is always valid: Caveat Emptor

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