# Liquidity Factor > The liquidity factor captures the extra return investors demand for holding hard to trade assets. Learn how illiquidity is measured, the evidence and its risks. Source: https://learn.tradelabsai.com/research/liquidity-factor/ Track: Research and Backtesting · Level: Advanced · Updated: 2026-10-03 Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice. Cite as: TradeLabs Learn, "Liquidity Factor", https://learn.tradelabsai.com/research/liquidity-factor/ Some assets are easy to trade in large size at a fair price; others are not. Investors generally require extra return for holding illiquid assets, because selling them can be slow or costly, especially in a crisis. The liquidity factor, or illiquidity premium, describes this extra return. It appears in stocks, bonds and private markets, and it is closely related to the risk that liquidity suddenly dries up across the market. Understanding it helps investors decide when illiquidity is worth accepting. ## Measuring illiquidity | Measure | Description | Lesson | |---|---|---| | Bid ask spread | Cost of a round trip trade | [Bid-Ask Spread](https://learn.tradelabsai.com/markets/bid-ask-spread/) | | Amihud illiquidity ratio | Average absolute return divided by dollar volume | [Measuring Liquidity](https://learn.tradelabsai.com/market-structure/measuring-liquidity/) | | Turnover | Trading volume relative to shares outstanding | | | Market impact | Price move per unit traded | [Market Impact](https://learn.tradelabsai.com/orders/market-impact/) | | Zero return days | Share of days with no price change, a sign of infrequent trading | | The Amihud measure, introduced by Yakov Amihud in 2002: ``` illiquidity = average over days of (|daily return| / daily dollar volume) ``` Higher values mean prices move more per dollar traded: less liquid. ## The evidence - **Amihud and Mendelson (1986)** found that stocks with wider bid ask spreads earned higher returns, consistent with investors requiring compensation for trading costs. - **Amihud (2002)** found that illiquid stocks earned higher returns and that market wide illiquidity affected expected returns. - **Pástor and Stambaugh (2003)** found that stocks more sensitive to market liquidity shocks earned higher returns, a "liquidity risk" premium separate from illiquidity itself. ## Two related ideas | Concept | Meaning | |---|---| | Illiquidity level | How costly an asset is to trade on average | | Liquidity risk | How an asset's value and liquidity respond when market liquidity dries up | Assets that become hard to sell exactly when investors most need cash, as in 2008 or March 2020, carry the most painful liquidity risk. See [Liquidity Risk](https://learn.tradelabsai.com/portfolio/liquidity-risk/). **Example: Liquidity in a crisis** In March 2020, even US investment grade corporate bonds and some Treasury securities became hard to trade at fair prices for several days. Bond ETFs traded at large discounts to the reported value of their holdings, because the underlying bonds were barely trading. Investors who held less liquid bonds and needed cash had to accept steep discounts. Those with patient capital were able to buy at attractive prices. See [The COVID-19 Crash](https://learn.tradelabsai.com/history/the-covid-19-crash/). ## Where the illiquidity premium appears | Market | Example | |---|---| | Small and micro cap stocks | Overlaps with the size factor. See [Size Factor](https://learn.tradelabsai.com/research/size-factor/) | | Off the run Treasuries | Trade at higher yields than on the run issues. See [Treasury Bills, Notes and Bonds](https://learn.tradelabsai.com/bonds-credit/treasury-bills-notes-and-bonds/) | | Corporate and municipal bonds | Less traded issues offer higher yields | | Private equity and private credit | Lock up periods; returns debated after fees | | Real estate | Slow to buy and sell | ## Harvesting the premium - **Patient investors** with long horizons and stable funding, such as endowments, can hold illiquid assets. - **Liquidity providers** earn a premium by trading when others must, such as market makers and contrarian buyers in crises. See [Market Making](https://learn.tradelabsai.com/strategies/market-making/). - **Costs matter:** the premium can be eaten by the very trading costs that create it, especially for active strategies. ## Risks - **Forced selling** when you need liquidity. - **Valuation uncertainty:** illiquid assets may be marked at stale prices, understating risk. See [Autocorrelation and Partial Autocorrelation](https://learn.tradelabsai.com/math/autocorrelation/). - **Crisis correlation:** illiquid assets tend to fall together in stress. - **Capacity limits.** See [Alpha Capacity and Crowding](https://learn.tradelabsai.com/research/alpha-capacity-and-crowding/). ## Frequently asked questions ### What is the liquidity premium? The extra return investors demand for holding assets that are harder or more costly to trade. ### How is stock illiquidity measured? With measures such as bid ask spreads, turnover and the Amihud ratio, which compares absolute returns with dollar trading volume. ### What is liquidity risk? The risk that an asset becomes hard to sell, or loses value, when market wide liquidity dries up, often during crises. Next, learn about growth, investment and dividend factors in [Growth and Dividend Factors](https://learn.tradelabsai.com/research/growth-and-dividend-factors/). ## Continue learning - Next lesson: [Growth and Dividend Factors](https://learn.tradelabsai.com/research/growth-and-dividend-factors/) - Previous lesson: [Carry Factor](https://learn.tradelabsai.com/research/carry-factor/) - Related: [Carry Factor](https://learn.tradelabsai.com/research/carry-factor/): The carry factor buys higher yielding assets and sells lower yielding ones across currencies, bonds, commodities and stocks. Learn how carry is measured. - Related: [Liquidity](https://learn.tradelabsai.com/markets/liquidity/): Liquidity is how easily you can trade without moving the price. Learn the signs of a liquid market, how illiquidity costs you and when liquidity disappears. - Related: [Measuring Liquidity](https://learn.tradelabsai.com/market-structure/measuring-liquidity/): Liquidity can be measured with spreads, depth, volume, turnover and price impact. Learn the key measures, formulas and how to use them before you trade. - Related: [Size Factor](https://learn.tradelabsai.com/research/size-factor/): The size factor says small companies outperform large ones over time. Learn the original evidence, why the effect weakened, the role of quality and how to trade it. - Related: [Liquidity Risk](https://learn.tradelabsai.com/portfolio/liquidity-risk/): Liquidity risk is the danger of being unable to trade quickly at a fair price, or running short of cash. Learn its two types, how to measure it and controls. - Related: [Market Impact](https://learn.tradelabsai.com/orders/market-impact/): Market impact is the price movement caused by your own trading. Learn temporary and permanent impact, the square root rule of thumb and how large traders reduce it.