Market liquidity affects everything from the bid-ask spread to order execution. Therefore, it is important to understand the meaning of this term well and to identify liquid and illiquid markets.
Source: Bloomberg
Market liquidity forex market capitalization commodity market bid-ask spread volatility

Written by

Becca Catlin
Financial writer
What is market liquidity?
Liquidity is how quickly an asset can be bought and sold at stable prices. Simply put, it is a measure of the number of buyers and sellers and how easily transactions can be completed. Generally, liquidity is calculated by measuring the volume of trades or the volume of orders currently pending in the market.
High liquidity levels arise when there is significant trading activity and when supply and demand are high for the asset, making it easier to find a buyer or seller. If the number of market participants is low and they are trading irregularly, the market is said to be illiquid or low liquidity.

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Why is market liquidity so important?
Market liquidity is important for several reasons, the most important being its impact on the speed of opening and closing trades. A liquid market is generally associated with lower risks, as there is always someone willing to take an opposite position on a trade. This attracts speculators and investors to the market, enhancing its favorable conditions.
In a liquid market, a seller can quickly find a buyer without having to lower the price of the asset to make it attractive. Conversely, a buyer will not have to pay a higher amount to secure the asset they want.
Asset liquidity is a fundamental factor in determining the price spread offered by a leveraged trading provider - like IG. High liquidity means a large number of buy and sell orders in the underlying market. This increases the likelihood of a closer match between the highest price any buyer is willing to pay and the lowest price any seller is willing to accept. In other words, the bid-ask spread will narrow.
Since we derive our prices from the underlying market prices, a decrease in the bid-ask spread here means a decrease in the price spreads displayed on the platform. If the market is illiquid, it may mean that there is a much wider price spread.
How to use liquidity in trading
When trading financial markets, liquidity should be considered before opening or closing any position. This is because a lack of liquidity is often associated with increased risk.
If the market is volatile but the number of buyers is less than the number of sellers, you may find it difficult to close your position. In this case, you might risk remaining in a losing position or have to deal with multiple parties at different prices just to execute your order.
One way to manage liquidity risk is to use guaranteed stop-loss orders, which are a type of stop-loss order that ensures your position will close at a price level you have previously set. Guaranteed stop-loss orders are not affected by volatility, making them a useful tool for dealing with turbulent markets. However, when a guaranteed stop-loss order is activated, there will be a small fee to pay.
The most important thing to remember is that market liquidity is not necessarily static; it moves on a dynamic range between high liquidity and low liquidity. The market's position on this range depends on multiple factors, such as trading volume and trading time.
If you are trading in an off-market or outside trading hours, you may find that the number of market participants is lower, and therefore liquidity is much lower. For example, liquidity may be lower for currency pairs quoted in GBP during Asian trading hours. This may lead to wider spreads compared to European trading hours.
What are the most liquid markets?
Forex (Major Pairs)
Large-cap stocks
Commodities
Although these three financial markets are among the most liquid, cash is actually the most liquid asset, as it can be used to purchase almost anything. Therefore, the liquidity of most other assets is measured by how quickly and easily they can be converted into cash.
Forex and liquidity
The forex market is considered the most liquid market in the world due to the large volume and frequency of trading.
Governments, all major banks, insurance companies, investment firms, traders, and even individuals on vacation contribute to the massive trading volume that occurs in the forex market daily. The trading volume in the forex market is estimated to exceed 5 trillion dollars daily.
Despite the high levels of liquidity in the forex market, prices do not exhibit stability. The number of traders in major pairs leads to differing opinions on the optimal price, resulting in daily price movements. This is especially evident when the market absorbs news. While this causes high volatility, prices usually remain within a defined range and trade in small increments.
It is generally assumed that major currency pairs - the most traded - are the most liquid. This means that pairs like EUR/USD, GBP/USD, and USD/JPY have high liquidity.
In the forex market, liquidity is important as it tends to reduce the risk of slippage, provides faster order execution, and tighter bid-ask spreads.
Large-cap stocks and liquidity
For a stock to be considered liquid, it must be possible to buy and sell it quickly with minimal impact on its price. According to Canadian regulatory bodies, a liquid stock is classified as one that is traded at least 100 times daily, with an average daily trading volume of at least one million USD.
Stocks of companies traded on major exchanges are typically highly liquid. These stocks are known as large-cap stocks.
For large-cap stocks to be classified, their market capitalization must generally be 10 billion USD or more. These stocks are typically considered blue-chip stocks, meaning they have a record of stable earnings and revenues. Traditional theories suggest that larger market capitalization companies enjoy stable prices and larger trading volumes, which means their shares can be converted to cash relatively quickly.
Commodities
Access to the market is related to its liquidity. Traditionally, commodity markets were considered much less liquid than other markets because the physical delivery of assets made speculation difficult. However, thanks to the proliferation of derivative products - including contracts for difference, spread betting, futures, exchange-traded funds, and ETFs - trading commodities has become easier than ever.
Liquidity levels vary depending on the commodity you wish to trade. The most traded commodities are generally the most liquid, such as:
Crude oil. Crude oil is perhaps the most traded commodity in the world due to its various uses and multiple trading methods.
Precious metals. Gold is the most liquid of the precious metals, witnessing the highest trading volume, and a wide range of different products is available that can be used to trade in the market.
Sugar. As the most common ingredient in our diets, sugar has also become one of the most traded markets. It was even known at one time as "white gold".