Liquidity is a key to trading. Trade illiquid stocks and you run the risk of getting stuck in a trade or, worse, buying or selling at the best bid or offer.
Bid-ask spreads tend to be wide on illiquid securities, and you could automatically be down on your trade if you enter a market order to buy or sell. That’s why you want to factor liquidity into the stocks you would consider trading.
Liquidity translates to how easily something can be bought or sold in the market. Cash, for example, is considered completely liquid, because people readily accept it as payment and it’s considered legal tender. Bonds, by comparison, or an investment in a house are illiquid, as it could take a while to find a buyer.
In trading, liquidity translates to volume. When trading volume is high, stocks are more liquid; you can buy and sell the security at will and with the best execution.
Why traders need liquidity
The bid-ask spread — the amount by which the ask price exceeds the bid price for shares on the market — is one key reason why traders need liquidity. Typically, stocks that are more liquid have a tight bid-ask spread — meaning the highest price a buyer is willing to pay is just above the lowest price that a seller is willing to accept; with illiquid shares, there’s typically a wider bid-ask spread, meaning you will have to pay up to convince a seller to move their shares.
Moreover, it can take longer to get your order filled, and you always want to be able to enter and exit your trades quickly and easily.
Let’s assume you get into a stock with an average daily volume of 50,000 shares, resulting in a wide bid-ask spread. Let’s say that to buy your shares, you lifted the offer when the spread was $1 wide. Consequently, you paid $1 more than the national best bid, and you could be down on the trade if bid prices don’t rise. Moreover, you might be unable to get out of your position without taking a massive loss.
If the stock was liquid, the bid-ask spread might be just a penny or two, allowing you to get in and out easily, without over-sized spread costs.
Liquidity is highly important, and you only want to trade stocks that have a high degree of it. One way to check for stocks that typically have good liquidity levels is via finviz.com and filtering for stocks trading over a million shares per day. Here’s a snippet of the screener on Finviz, which filters for stocks with an average daily volume of over one million shares and market capitalization of at least $300 million.
These stocks should offer the liquidity and tighter bid-ask spreads most traders are looking for.
Jeff Williams is the lead trader of PennyPro.com. He is a short-term trader of stocks under $10 a share.
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