Stock market liquidity refers to how easily and cost effectively a stock can be traded in the open market. It is generally dependent on the following four factors
- a narrow bid-ask spread
- trade volume is high
- trade value is high relative to market capitalization
- share turnover
If each of these criteria is fulfilled, the act of buying or selling the stock will have little impact on the stock’s price.
A liquid stock, for example Google (GOOG, GOOGL) may appear to have a wide bid-ask spread, but the actual % difference between the two is minimal. The same analysis applies to the traded volume. This may initially appear lower than other popular stocks, but the level of the stock price means the actual traded value is extremely high. Thus, the stock is considered liquid.
Volume is one the measures used by Merger Arbitrage Limited when filtering candidates for inclusion in the T20 Merger Arbitrage Spread Index. The more volume the easier it is to get in and get out of trade. In this case, we specify a minimum volume of 250,000 shares per for the previous three months.
Share turnover is a measure of stock liquidity calculated by dividing the total number of shares traded over a period by the average number of shares outstanding for the period. The higher the share turnover, the more liquid company shares are.
Liquidy Issues for Illiquid Stocks
IIliquid stocks can have a much larger spread, sometimes as much as 10% or more, especially for smaller companies. This illiquidity deters other traders from entering the market thus reducing liquidity further in a negative spiral.
Further academic analysis on analysing stock market liquidity can be found in Sedeaq Nassar’s 2016 paper “Investigate the Factors Affecting Share Liquidity: Evidence from Istanbul Stock Exchange (ISE)“. Although this focuses on the Turkish exchange it is a recent paper applicable to many developed global markets.
