Understanding Liquidity and Volatility in Stocks

Volatility and liquidity are the two terms that you will come across every day in your journey of investing in the stock market. These concepts impact everything from placing a trade to its execution. Liquidity, for example, can prevent you from selling your stocks in the absence of buyers.

The stock prices do not fluctuate randomly. Liquidity and volatility are the two silent forces behind all the rises and falls and abrupt pauses. This is why it’s important to have a firm understanding of the liquidity and volatility of stocks.

What is Liquidity in Stocks?

Liquidity in the stock market refers to the ease with which you can buy or sell stocks. Suppose you own stocks of a company and want to sell them, but there are no buyers. This means the stock market is illiquid. The stock is said to be liquid if you can trade fast, at a reasonable price, with minimal effort. Investors have a couple of indicators that they consider to indicate liquidity:

One is trading volume. Stocks that trade frequently usually have better liquidity.
The other one is the number of buyers and sellers at any given time. The more participants, the more opportunities to trade without any issues.

A high stock liquidity allows you to get in or out of a position with ease. Now consider the concept of liquidity at a common level. Trading is easy when there is a large number of buyers and sellers in the market. The prices remain constant since demand and supply are always in balance. The same applies to the stock market. The more active a stock is, the more liquid it becomes.

Example of a Stock Liquidity

You have decided to purchase 1,000 shares of a well-known technology stock. Since the stock is very liquid, your order is filled immediately at the price that you see on the screen. However, suppose you attempt the same with a small, little-known stock. There are just a few buyers or sellers at that time. You might buy it and raise the price, or you might sell it and drive the price down. That disparity demonstrates the importance of stock liquidity.

Importance of Liquidity in the Stock Market to Investors

Liquidity directly affects the way investors feel about the stock market. A liquid stock is easy to trade, whereas an illiquid one may give unexpected results. Here is why stock liquidity is important for investors:

Quick trade execution: Highly liquid stocks allow you to sell or buy at the price you can set. It saves time that would otherwise be wasted during delays that may affect your investment strategy.
Reduced transaction costs: Liquid stocks tend to have smaller bid-ask spreads, which implies that you pay less for unnecessary price differentials when trading.
Less chance of distortion of prices: In liquid markets, even large trades are absorbed without any sudden, unexpected jumps or falls in the stock price.
Flexibility to respond to opportunities: Liquidity provides the freedom to enter or exit a stock as market conditions evolve. Therefore, you can take advantage of opportunities without being hindered by low activity.
Favors long and short-term plans: To long-term investors, liquidity guarantees easy exits when they are required. To active traders, it is necessary to get in and out of positions effectively.
Better predictability in decision-making: Knowing that a stock is liquid allows you to plan trades and risk management with greater confidence, eliminating the stress of sudden market action.

The lack of liquidity may result in a broader bid-ask spread, i.e., you may pay more to buy or receive less to sell. In a liquid stock, these gaps are fewer, and you have more of your money where it belongs, invested in the stock, not thrown away on superfluous price fluctuations.

What is Volatility in the Stock Market?

Volatility in stock market is a measure of the rate at which the stock price increases or decreases. It is determined by calculating the standard deviation of the annualised returns over a certain time period and shows the risk related to the security's fluctuating price. Put more simply, it is a measure of how quickly the value of stocks or market indexes fluctuates.

Volatility can be useful to consider as uncertainty + opportunity. The more uncertain a stock is, the faster and wider it moves. Simultaneously, the same swings provide investors with the chance to purchase low and sell high. Stock volatility may be regarded from two perspectives:

Speed of price movements: There are those stocks that move fast within minutes or hours, and others move slowly. Stocks that move fast are more volatile, which provides traders with opportunities to respond and risks of responding too slowly.
Extent of price movements: A stock that moves between 50 and 60 in a week is more volatile than one that moves around 50. The bigger swings indicate greater volatility.

Importance of Volatility in the Stock Market

Volatility is not a figure on a graph, but it determines the way investors feel about the market. Knowing the reasons why volatility in the stock market can help you make wiser decisions and remain calm when prices are fluctuating. Here is why volatility is important for investors:

Indicates possible opportunities: Increased volatility of stocks implies that prices fluctuate more, which provides the opportunity to purchase at low prices and sell at high prices.
Helps determine risk: Volatility indicates the extent to which the price of a stock can vary within a period of time. This allows investors to know the possible ups and downs in prices.
Time the market entry or exit: Knowledge of volatility in the stock market lets investors plan when to buy or sell instead of acting on impulse when there is a sudden change.
Influences emotions: Understanding that fluctuations in prices are normal enables investors to avoid panic selling or buying on impulse when the market is fluctuating.
Effects on various investors: Long-term investors will be able to endure short-term fluctuations, whereas short-term traders can take advantage of rapid price changes.
Promotes informed decision-making: Understanding volatility helps investors align stocks with their risk tolerance and investment objectives, instead of making decisions without understanding.

Volatility has a direct impact on risk perception. When the prices fluctuate suddenly, the market may not be stable. This perception may affect your decision, although the underlying stock fundamentals may not have changed.

Liquidity vs Volatility: The Key Difference

Here are the key differences between the stock liquidity vs volatility:

Although they are independent, they tend to interrelate in significant ways. Liquid stocks are more likely to absorb trades, and this may smooth out extreme price movements. Conversely, low liquidity stocks can experience exaggerated price movements, despite the placement of small orders. This increases the risk and uncertainty in trading in illiquid stocks.

Role of Liquidity and Volatility in Investment Decisions

Liquidity and volatility are best understood as a pair that provides investors with a practical perspective of making wiser decisions. They both influence the ease with which you can trade, the risk of a stock, and the comfort with which you are going to hold it.

Risk tolerance: When you are comfortable with highs and lows, you can bear a volatile stock, even a highly liquid stock. Low-volatility, liquid stocks are a safer option in case you want stability.
Time horizon: Long-term investors can afford the volatility in the short run without much concern about liquidity. Short-term traders, in their turn, require high liquidity and manageable volatility to enter and exit positions effectively.

Conclusion

It is easy to mix up liquidity and volatility, but they are different and also offer varying benefits. Purchasing a very volatile stock without looking at liquidity will put you in a situation where it is difficult to sell. On the other hand, being liquid without knowing about volatility may leave you vulnerable to unexpected price changes.

Liquidity and volatility are not about risk avoidance, but rather about risk management. By understanding the two, you can select stocks that will suit your risk tolerance, your time horizon, and your investment strategy.