How to assess liquidity in stock investments

In this article, you can get a clear-cut insight into liquidity assessment. But first, let us start with the basics.
How to assess liquidity in stock investments

To date, cash and cash equivalents are considered the most convenient way to transact. This is because they are highly liquid assets. You must have heard the term ‘liquidity’ plenty of times. However, have you ever wondered what role it plays in stock investments? Liquidity essentially determines how soon you can convert an asset into cash for transacting. And it is a quintessential factor when it comes to making investments in avenues like the stock market.

What is liquidity?

The ease with which you can convert an asset into cash is termed liquidity. Different categories of assets have different levels of liquidity. Marketable securities, for instance, have a ready market. This increases their liquidity as one may quickly sell and get cash in exchange. In contrast, fixed assets such as real estate may take longer to sell or liquidate. This renders it illiquid.

Tangible assets, such as valuable paintings, automobiles, or any form of collectibles are also fairly illiquid. By this measure, cash becomes the most liquid asset there is.

To understand the implications of this concept, let us take an example. Assume that you wish to purchase an air-conditioner worth Rs. 50,000. However, you do not possess cash at the time. Instead, you have an antique worth the same amount. It will be quite tough to find someone interested in buying that antique, so you can get some cash. This makes keeping cash in hand necessary since it’s the most hassle-free and widely accepted medium of exchange.

What is a market’s liquidity?

Market liquidity refers to the asset’s marketability, transparency, stability, and capability to turn itself into cash. High market liquidity is marked by the ascending supply and demand for the asset. Assets that have high market liquidity include:

  • Shares and debentures
  • Commercial papers
  • Government bonds and treasury bills
  • Certificates of deposits

With thousands of ready buyers and sellers in the stock market, shares of a publicly-traded organisation are considered highly liquid. Let us understand the liquidity position of the stock market.

Liquidity in the stock market

The stock market is a platform that allows easy and quick buying and selling of securities of listed companies. Stocks of companies are widely traded in the stock market. A stock’s liquidity is measured by how seamlessly it can be bought or sold, without causing major fluctuations in its market price. Those stocks which are most widely traded in the market and have large market capitalisation are also amongst the most liquid stocks.

You can divide stocks into liquid and illiquid ones. Let us see how this classification works.

Liquid stocks

Stocks listed on the major stock exchanges, such as NSE and BSE, are generally liquid. Even in a downturn, it is fairly easy to buy and sell such stocks. Moreover, you may classify them based on their market capitalization into large-cap, mid-cap, and small-cap stocks.

Large-cap stocks have a market cap of Rs. 20,000 crore and above. Mid-cap stocks have a market cap between Rs. 5,000 crore and Rs. 20,000 crore. Whereas, small-cap stocks have that Rs. 5,000 crore or less.

It does not involve a lot of effort to sell large-cap stocks as they have a higher demand in the market. On the other hand, mid-cap stocks offer comparatively lesser liquidity. Small-cap stocks are the least liquid among these three categories, making it a task to trade them.

Illiquid stocks

When you face difficulty in selling a stock, and can only do so at a significant loss, it is usually because the stock is illiquid. Such stocks are not traded regularly and thus do not have ready buyers. Due to the lack of liquidity, there is a higher risk involved for the investor. You must do proper research while investing and aim to avoid such shares.

Now that we have discussed the types of stocks on the basis of liquidity, let us see the factors involved in doing this classification.

How to determine the liquidity of stocks?

Before investing, it is crucial to assess the liquidity in the stock investments. There are various factors that will help you determine whether a stock is liquid or not. These include:

Volume of trade

The volume (or trading volume) is calculated for a specific period. It indicates the number of times a stock has changed hands during that time frame. This includes both buying as well as selling of the stock. This means if a company’s 500 stocks was first purchased and sold in a day, its trading volume would be 1000.

If the volume of trade is high, it means there is a large number of buyers and sellers of that stock in the market. It further implies that the stock is highly liquid.

You can check the volume of trade in a day in the reports released by the stock exchanges. Most reports declare volumes of particular shares and the total volume of trade in a day.

Turnover of shares

You can calculate share turnover by dividing the number of shares traded and the number of outstanding shares over a specified period. It tells you the number of shares traded compared to how many shares could have actually been traded. A higher value so calculated signals higher liquidity of the share.

This measure, just as the previous one, determines the ease with which you can buy or sell a share. However, it only focuses on the quantitative aspect of trade and does not indicate anything about the quality of the shares.

The bid-ask spread

The bid-ask spread is the gap between the ask price and the bid price of a share. In simple terms, it is the difference between the lowest price that a seller may accept for a share and the highest price that a buyer will pay for it willingly. However, it is a de facto measure of liquidity.

The bid indicates demand and the ask shows the supply of the stock. A lower bid-ask spread indicates more liquidity and vice versa.

Importance of liquidity in stock investing

It helps to accelerate transactions

Liquid stocks have more buyers and sellers. This makes it easier to trade such shares. Effectively, you can accelerate your transactions and trade with ease.

It eases the selling process

It is way more convenient to sell a stock that has high liquidity than an illiquid one. Usually, the popular shares have a wide market, where buyers are ever-ready to buy. These shares, as you can tell, are very liquid. This makes it easy to cash-out these assets. Penny stocks, on the other hand, may enter periods of illiquidity where no transactions happen as the buyers and sellers are mismatched.

It helps to retain value

Liquid assets have the tendency to retain their value. In some cases, their value may increase with time. In case of any financial emergency, if you break open your long-term illiquid assets, their value may have already depreciated. But in the case of liquid assets like stocks, it doesn’t happen.

In conclusion

Liquidity is a major deciding factor while investing in the stock market. It is the metric that gives you the idea of how quickly you can get cash in exchange for your assets. We at TejiMandi help you find the right stock investments by analysing their liquidity, among other crucial measures.

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