Stock Trading 101 – Avoid Illiquid Instruments

One of the important properties of any financial asset is its liquidity or how quickly you can dispose of it and turn it into cash. The ability to convert illiquid assets into cash it not the only limitations such assets have. If you have an illiquid financial instrument and are holding a large position in it, your risk is not only that you are unable to sell it to anyone else, but when doing so you will move the entire market. If you are forced to sell a stock to limit your losses for example, you will only increase the magnitude of such losses because you will start moving the market yourself and create the selling pressure you would like to avoid which drives the price further and further down.

In trying to evaluate an instrument’s liquidity it is important to understand the overall liquidity of the market you are in. Your liquidity requirements will depend on the size of your position and the speed with which you want to be able to most efficiently unload it. If you want to buy only 1,000 shares, almost any stock that has a 1,000,000 daily volume (maybe even less) will be sufficient. If you want to acquire a position in the millions and still be able to close this position within minutes or hours, this same stock is probably not the right choice if you want to achieve the best possible exit.

Illiquid instruments are also characterized by potentially wider spreads in their bid and offer prices. This wider spread arises because of the lack of competition and the limited number of sellers and buyers that are interested. This adds additional pressure to the investors who need to dispose of an asset in this category and who still want achieve optimum closing price for their position.