In simplest terms, liquidity describes how easily an asset or security can be purchased or sold without significantly affecting its price. If there is a high demand for a stock, it means that the market is more liquid, allowing investors to easily buy and sell that stock.
The term liquidity can be applied to any capital market such as equities, precious metals, commodities, and more.
In other words, market liquidity essentially serves as a measure of how easily traders can buy and sell securities. Liquid markets are defined by high trading volumes and a close spread between ask and bid prices.
In normal circumstances, high market liquidity is a big benefit. Capital markets that have plenty of liquidity allow traders to efficiently and swiftly exchange assets and enable them to quickly open and close positions. Such opportune market conditions often lure more traders and investors, which ultimately adds even more liquidity.
On the other hand, markets with low liquidity can make it very difficult to trade the underlying assets as it can take a long time to execute the transaction. Furthermore, in low liquidity markets, it can take a while for buyers and sellers to agree on the price, which ultimately results in wide bid-ask spreads and elevated execution fees.
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