Ihab Salloum[ad_1]
Liquidity risk, my friends, is the risk that a stock may not be able to be traded quickly or efficiently enough in the market to prevent a devastating loss (or make a much-needed profit). In other words, it’s the possibility that you may not be able to buy or sell a stock for a reasonable price within a relatively short period of time.
Now, pay attention, because lack of liquidity is most commonly evidenced by a wide spread or price difference between the bid/offer. A wide spread, due to low average trading volume in a particular stock, typically results in purchase and sale price inefficiencies. The bid-offer spread is what market participants use as an asset liquidity measure, because it’s composed of operational, administrative, and processing costs, as well as the compensation required for the possibility of trading with a more informed trader.
My dear reader, liquidity risk arises when a party interested in trading an asset cannot do so because nobody in the market wants to trade that stock within the bid and ask price. This can lead to lack of liquidity, which directly affects your ability to trade and can also contribute to slippage, which is the difference between your estimated transaction costs and the amount actually paid.
But don’t you go confusing liquidity risk with a drop of price to zero, my friends. A drop to zero means the asset is worthless. However, if you cannot find another party interested in trading the stock, this can potentially be a problem of you and potential market participants finding each other, leading to liquidity risk. This risk is most commonly experienced in emerging markets or low-volume markets.
My friends, let me tell you that liquidity risk tends to compound other risks. If you hold an illiquid asset, your limited ability to liquidate your position at short notice will compound your market risk. This means that if you can’t sell a stock due to lack of liquidity in the market, it then becomes a sub-set of market risk!
So, how can we avoid liquidity risk? Listen up now, because the best way to do so is to only invest in stocks that have an average daily volume of at least 500,000 shares or more. Higher volume for a stock is an indicator of better liquidity. An adequate volume typically ensures enough daily activity between buyers and sellers to keep the spread between the bid/offers relatively narrow. A narrow spread means greater efficiency, less slippage, and fewer surprises about the price you expect to get when buying or selling stock.
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