Updated: Aug 30, 2021
‘Liquidity is the new Leverage’ - Charles Himmelberg, Head of Global Credit Strategy, Goldman Sachs.
The above quote comparing liquidity to leverage highlights the importance of liquidity.
Liquidity plays a crucial role in the current investing world, where confusing Bank Regulations, Algo Trading, and Quant trading bring enormous risk in trading.
What is the Definition of Liquidity?
‘Liquidation’ is the process of selling an asset in return for its monetary value at the time of sale.
For example, a trader owns 1000 shares of HDFC, which he had purchased at 2300 a few months back. Now one share is worth 2600, and he decides to book the profit by selling them at 2600.
Two things define the outcome of the sale:
How easily can he sell all his 1000 shares?
What is the execution price for his 1000 shares?
The same questions apply on the buying side as well.
Hence, liquidity refers to the ease with which a trader can buy or sell a stock.
Stocks that are popular and have high trading volume can be bought and sold with a slight change in the price (compared to the market price) when the trade is completed.
What are Liquid Stocks?
In simple words, a liquid stock is a stock that trades enough shares (volume) every day so that a trader can buy or sell quickly at the current market price (with less slippage).
A stock can be considered as a liquid stock when:
The trading volume is high every day
The difference between the ‘bid’ and ‘ask’ is less
The stock has a high float
If you look at the daily chart of Reliance, it has received over 20 million volume every day. It means over 10 million shares are bought and sold every day. On 10-Sep-2020, it has received over 64 million volumes, and it indicates Reliance is a highly liquid stock.
How Does Liquidity Affect Trading?
Liquidity plays a crucial role in trading.
For example, a penny stock XYZ is trading at Rs.6 (CMP).
A trader has a bullish view on XYZ and hence decides to buy 1000 shares at Rs.6. He places an ‘MKT’ order with 1000 as purchasing quantity.
But to his surprise, 500 quantity is bought at 6.5, and the remaining 500 quantity is bought at 7.5.
This incident happened because, even though the current price is 6, there are no sellers at 6. The only seller was available is at 6.5 (500 shares) and 7.5 (shares).
In this case, the trader has bought the shares by paying an extra 16.7% than the current market price.
These kinds of experiences are common in illiquid stocks. Remember, the same trader might lose more % again while selling the same 1000 shares.
Hence, it is always essential to manage trades in liquid stocks.
How to Identify Highly Liquid Stocks in India?
There are many ways to identify liquid stocks in Indian Markets. Below are the two simple methods:
Most Active Equities in NSE
After the end of every trading day, NSE lists the top-20 highly liquid stocks (highest volume trader).
It is a simple way of getting the high liquid stocks information in the Indian markets.