Understanding Liquidity When Trading Stocks

Cobra Trading
Jan 24, 2022

Liquidity refers to the number of shares traded on the market for a particular stock at that moment. A stock with a low volume is considered to be an illiquid stock, and a high number of shares involved in trades signals that the stock is a liquid stock.

How does that affect you as a day trader? If the market for a stock is thin and contains only a few players, any surge in orders can make traders chase the entry and exit prices. Let’s imagine that there is a bid of 400 shares at $1.50 and an ask of 400 shares at $1.51. There’s a thin bid and ask, but they currently match, so the prices will likely stay in that range as the orders go through. 

But what if there’s a bid for 100,000 shares? A new order will throw the market out of balance, and the price will likely skip because the supply is severely limited. Stock’s illiquidity led to a single order impacting the price. Hence, illiquid stocks tend to be much more volatile. So, if you trade 10,000 shares within a single order but the stock has a total volume of 100,000 during the day, your trade may be in quite a vulnerable position. Day traders must understand liquidity and trading volume to know whether they are exposed to more or less risk in a specific trade. 

Alternatively, consider a scenario where a bid is $1.25/share while the ask is at $1.50/share. The difference between these two prices is known as the spread; generally, the smaller the spread, the greater the liquidity and vice versa.

That is why bigger traders typically prefer stocks with thick liquidity. A higher number of shares traded at any moment means that you can place your order more predictably. Traders should be able to get in and out pretty quickly, and slippage will be less likely. A single order won’t sway the stock’s price, and your order to sell or buy won’t make a significant dent in the overall picture. Given the higher total volume, your order will be more likely accompanied by counteroffers on the market no matter if you’re going short or long.

As you know, making an entry and exit as planned is a huge advantage. Traders rely on it to make a profit. However, it’s important to remember that many factors are at play. Choosing a stock with high liquidity doesn’t always guarantee predictable results since Black Swan events can occur even in thick markets. Nevertheless, trading a high liquidity stock protects you from seeing a price jump based on a single order.

It may seem that stock liquidity matters only if you’re trading with a large position, but that’s not exactly true. Every day trader should take volume into account. In the beginning, your size may only be 100 shares, so your trades won’t cause price change even in thin markets. But as you increase your position, the number of shares you move within any given trade will increase, and stock liquidity will become more and more important. This is why we recommend paying attention to liquidity early on. By the time you are a seasoned day trader and ready to trade thousands of shares, you’ll be used to looking at liquidity and factoring it into your decision-making process. This way, you won’t have to adjust your habits whenever you’re ready to scale. Your strategy will be consistent regardless of the volume traded, and the trade will follow the same rules no matter if you trade 100 shares or 100,000 shares.

Additionally, remember liquidity is not constant. You can check the average volume on Yahoo Finance or other websites that cover the stock market. This information will give you a frame of reference and help you determine how volatile the stock is likely to be on any given day.

Check out more day trading information on our blog. And if you’re looking to open an account with Cobra Trading, you can start the process right here.

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