Importance of being liquid
There are many confusing measures about share liquidity - here's the practical one.
I recently read a fascinating statistic. At the end of World War II, a US stock was held, on average, for four years; in 2008, the average had fallen to two months and in 2011 it had fallen to 22 seconds.
The main reason for the dramatic drop has been the rapid development of high frequency trading, a phenomenon that has caught on around the world.
Statistics like that might sound like good news for the average punter. After all, with more shares being traded each day, surely that makes it easier to buy and sell shares. Or to use a market term, surely the sharemarket has become more "liquid".
However, before you jump to that conclusion it is important to realise that share liquidity is not defined so simply. This article explains what share liquidity is, how you can measure it in a practical sense and, most importantly, how to make it your slave, not your master.
The meaning of liquidity
Shares are considered to be liquid if they can be rapidly sold (implying they can also be rapidly bought) and the act of selling has little impact on the share price. So - how you can judge the liquidity of a listed company's share before you take the plunge.
There are many different ways share liquidity can be measured. For example, on an average day, it can be described as the total number of shares traded; the total value of shares traded; turnover (the proportion of a company's total tradeable shares traded); how regularly trading occurred; the price spread between what buyers wanted to pay and what sellers wanted to receive; or even how resilient the quoted share price was to given volumes of trade.
But what you need is a practical way of looking at things; to judge if there is sufficient depth of trade to comfortably establish a position where you choose to buy and comfortably convert that position into cash when you choose to sell.
Importantly, liquidity has a personal side. A small investor wishing to buy or sell a few hundred shares is nearly always going to find sufficient liquidity to meet their needs. However, a large institution wishing to buy or sell a million shares at a time needs to limit their fishing to the bigger ponds.
If your needs are somewhere between these two extremes, here are some practical tips to avoid getting caught attempting a trade when everyone else has left the party.
How to judge liquidity before you trade
A practical starting point is to check the stock's average daily trading volume. Yahoo Finance provides up-to-date averages for every stock on its website. Bring up the company you are investigating and click on 'Key Statistics'. Daily averages are shown for the previous 10 days and three months. If the two figures vary significantly, investigate the reason. One might be atypical.
Once the average is found, it is useful to compare it to the size of your own shareholding, be it actual or intended. If the typical daily trading volume is significantly higher than the volume you wish to trade, it should provide you with a degree of comfort.
It is worth checking your broker's web page. For example, CommSec displays the daily trading volume for each listed stock on every trading day for the previous 12 months (click on 'Trade History'). You can also access the price, volume and total value of all trades executed so far for the day you make the inquiry (click on 'Course of Sales').
Check the market depth just before placing your order. You can access this on the quotation page of your broker's website, which displays the number of shares both bid for and offered in live time.
If insufficient shares are being bid for or offered within the price range at which you wish to trade, it is not advisable to place an "At Market" order, or you will probably end up buying or selling at some pretty unfavourable prices. It's much safer to place an "At Limit" order.
Liquidity and the long-term investor
In theory, liquidity doesn't matter to the long-term investor, but in practice it may, depending on circumstances.
The world's most successful investor, Warren Buffett, has said that if you are not willing to own a stock if the exchange shuts down for five years after purchase; you should not buy the stock in the first place.
They are not idle words. Berkshire Hathaway, the company he heads, has acquired around 90 unlisted companies in the time he has been at the helm, indicating he is not scared of buying relatively illiquid businesses.
But it is important to add that buying into investment situations that are difficult to exit requires supreme confidence in your ability to judge the future business prospects for the company. Let's face it, when things start to go pear-shaped, most "investors" (and pretty much all traders) prefer the comfort of being able to get out quickly.
Can I profit from illiquidity if it causes a stock to trade at a discount?
If you fancy yourself as a hot-stock picker, illiquidity might be the very best friend you have. That is because most investors and traders avoid less liquid stocks, so there is a tendency for these overlooked equities to trade at a discount.
That does not mean investing in a randomly selected group of illiquid stocks will guarantee market-beating returns. Skill in selection is still required, so it's a sport reserved for budding Warren Buffett types.
The liquidity of ETFs
Exchange-traded funds, (ETFs) are investment funds that are bought and sold on an exchange. For this reason, when they originated, they were widely viewed as a more liquid alternative to mutual funds.
But the factors underlying their liquidity require special mention. That is because of the market-making mechanism underlying their creation. Increased demand for the shares of a particular ETF can result in new shares being created by the market maker. Therefore, the liquidity of an ETF also depends upon the liquidity of the securities it is invested in.
Generally speaking, that means ETFs that invest in large-cap stocks, developed economies, broad market indices and investment-grade bonds, will be the most liquid.
About the author
Michael Kemp is chief analyst at The Barefoot Blueprint.
The ASX Charting tool can be used to show liquidity. The vertical green lines in the bottom of a company price chart show if turnover in that security is rising or falling.