Liquidity is a trading term that describes the relative speed with which you can enter or exit a trade at a specific price and the overall interest and trading activity in a stock and its options.
Liquidity is the first thing that traders should consider when choosing a stock, ETF, and options. A liquid trading product (e.g. stock, ETF or option, etc.) has lower slippage, which is the difference between the execution price of a trade and the fair value of the trade. The reason is that a liquid product has more trading activity, with more market participants buying and selling at the current market price. The effect is to narrow bid/ask spreads and increase the likelihood of executing a trade closer to fair value, which is defined in practice as the average of the bid/ask prices.
Liquidity isn’t one specific number, but rather a judgment that you make about a product based on its trading volume, width of its bid/ask spreads, and open interest (for options). Trading volume of millions of shares of stock or hundreds of contracts of options per day is a good indication of liquidity. The width of bid/ask spreads is more variable based on the price of the product, but narrower bid/ask spreads is better. .01 difference between the bid/ask is the “tightest” markets that you can see, indicating good liquidity. .05 difference is also acceptable, but you will see wider bid/ask spreads in liquid products like SPX, for example. Open interest in the thousands across all the options for a stock, ETF or index is a good indicator of liquidity.
A trader evaluates all these numbers to judge a product’s liquidity. At tastylive, we say “liquidity trumps all”, which means that no matter how strong an opinion we have that a stock might go higher or lower, we won’t do that trade if the stock or its options aren’t liquid. The way we deal with that is to find another stock that’s highly correlated to the first stock, but is more liquid, and we’ll trade that stock instead as an alternative to the first stock.
This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.