Measuring Liquidity

Saying a market is "liquid" or "illiquid" is useful, but traders and risk managers need numbers. Liquidity has several dimensions, and no single measure captures all of them. This lesson covers the main measures, what each one tells you and how to use them to decide what and how much to trade.

The dimensions of liquidity#

Spread measures#

Quoted spread % = (Ask − Bid) ÷ Midpoint × 100
Effective spread % = 2 × |Trade price − Midpoint| ÷ Midpoint × 100

The quoted spread is what you see on screen. The effective spread measures what trades actually pay relative to the midpoint, capturing price improvement or slippage. Tracking spreads at different times of day reveals when a market is cheapest to trade. See Bid-Ask Spread.

Depth measures#

Add up the size available within a set distance of the midpoint, such as 10 basis points or 5 ticks, on each side. Comparing that depth with your order size shows whether you can trade without walking the book. See The Order Book and Market Depth.

Volume and turnover#

• Average daily volume (ADV): shares or contracts traded per day, usually averaged over 20 days.
• Dollar volume: volume times price, comparable across assets.
• Turnover: volume divided by shares outstanding or free float.

Price impact measures#

Price impact estimates how much prices move per unit traded.

• Amihud illiquidity ratio: the average of absolute daily return divided by daily dollar volume. Higher values mean prices move more per dollar traded, a sign of illiquidity. It is popular in research because it only needs daily data.
• Kyle's lambda: from market microstructure theory, the price change per unit of net order flow.
• Square root impact models: estimate impact from order size relative to volume and volatility. See Market Impact.

Practical liquidity checklist before a trade#

1. Spread: what percentage of price is it right now?
2. Depth: is there enough size at the best prices for your order?
3. Volume: what is your order as a share of average daily volume?
4. Time: are you trading in a liquid part of the day?
5. Exit: could you get out quickly in a stressed market at a reasonable cost?

Liquidity changes, especially in stress#

Liquidity measures taken on calm days can badly overstate liquidity in a crisis. Spreads widen, depth disappears and resilience falls just when many traders want to exit. Risk managers therefore look at liquidity in stressed periods and use it to set position limits. See Liquidity Risk.

Frequently asked questions#

How do you measure a stock's liquidity?#

Look at the bid ask spread as a percentage of price, the depth of the order book near the price, average daily dollar volume and estimates of price impact.

What is a good average daily volume?#

It depends on your size. The key is that your typical order is a very small fraction of daily volume and of the size shown at the best prices.

What is the Amihud measure?#

A research measure of illiquidity: the average ratio of absolute daily return to dollar volume. Higher values indicate that prices move more per dollar traded.

Sources#

• Wikipedia, Market liquidity