Heads-Up: Upswing Resilient Investor Guide - Stock Liquidity

 

Let’s dive in liquidity of stocks [1,52-54] and related BI indicators such as the Average Daily Traded Volume (ADTV) and Share Turnover (SHT),  Depth of Market (DOM), Bid-Ask Spread (BAS) and optional Variance Ratio (VR).  Liquidity refers to the efficiency or ease with which an asset can be converted into ready cash without affecting its market price. The easier it is to buy and sell an asset, the more liquid it is. Liquidity applies to any financial market, from stocks to precious metals, but some are more liquid than others. The most liquid asset of all is cash itself. Tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquid. Most securities, such as stocks, ETFs, mutual funds, bonds and commodities are liquid assets. The most liquid market in the world is forex [53].  

Generally, stocks of companies with the largest MC are quite liquid (Green). If a stock cannot be sold easily without a considerable loss, it is considered illiquid (Red). Such stocks are more high-risk to investors as it might be harder to find a buyer unlike stocks that are traded frequently. Securities that are traded over-the-counter (OTC) such as certain complex derivatives are often quite illiquid [1].

Liquidity risk is the risk that investors won’t find a market for their securities, which may prevent them from buying or selling when they want. This is sometimes the case with complicated investment products and products that charge a penalty for early withdrawal or liquidation such as a  certificate of deposit (CD) [55].

But how to measure liquidity in the market? Fortunately, there are a few indicators that can be used to assess how liquid a market is: trading volume, BAS, turnover ratios, etc. [53].

Accounting liquidity is measured with specific ratios [1,56]: Current Ratio (CUR), Quick Ratio (QR), Acid-Test Ratio (ATR) and Cash Ratio (CAR).

What is Average Daily Trading Volume (ADTV)? ADTV is the average number of shares traded within a day in a given stock. Daily volume is how many shares are traded each day, but this can be averaged over a number of days to find the average daily volume. ADTV is generally compared to either the daily volume or another average calculated over a different time frame, to find how much volume is changing. There are two reasons to pay attention to ADTV: (i) to make sure a stock is liquid enough to get in and out of it quickly and (ii) to make sure the current supply and demand of stock traders was on your side. ADTV is also used by the SEC to ensure companies don’t buy back more shares in one day than the market can handle [55]. The ADTV formula is

ADTV(n days) = (Total Volume Traded During n Days)/n,

where n is the number of days you want to calculate the average daily volume for (e.g., to get the 30-day average trading volume, n=30)[58]. You can calculate the total volume of a trading day by just tallying up the number of times shares changed hands that day. Say, for instance, that Trader 1 buys 700 stock, Trader 2 sells 1000 stock, and trader 3 buys 2000 stock. Then the total volume for that trading sequences would be 700 + 1000 + 2000 = 3700. So say for example that the total volume for a particular company over a 30-day period was 750 million. The ADTV would be 750 million/30 days = 25 million.

TIPS [1]:

(1) You would prefer higher ADTV compared to low ADTV, because with high volume it is easier to get into and out positions. Low volume assets have fewer buyers and sellers, and therefore it may be harder to enter or exit at a desired price.

(2) Monitor ADTV regularly to make sure that the asset still falls within the volume parameters you desire for your trading.

(3) Significant changes in ADTV may signal that something has changed within the asset, and that some further action may be required (Amber).

(4) These are the most liquid market to remember – forex, stocks and commodities.

(5) If you are only planning to buy 100 shares of a stock, the ADTV is pretty much a non-issue because it will be easy to exit such a small position–even in a thinly traded stock. So size does matter (at least when it comes to stocks).

If you notice that ADTV for a particular security is increasing, then that could mean the security has higher liquidity as more buyers and sellers are in the market for it.  Conversely, if ADTV is falling, then that could mean investors are becoming more hesitant to trade in that stock. In general, if a security has a high ADTV it means it is more competitive, has narrower price spreads, and that it is less volatile to rapid changes.

What should be the minimum ADTV requirement for the stocks and ETFs you trade? Although there are free financial websites that provide you with the ADTV, the fastest and best way to gauge the liquidity of a stock is by plotting the data on a stock chart of a quality trading platform [59]. As a general rule of thumb, an ADTV of 20 million or greater provides pretty good liquidity for most traders. By knowing the Average Dollar Volume of a stock, you can lower your minimum ADTV requirement if the stock is trading at a higher price.

Further, Average Dollar Volume (ADV) is a metric that is calculated by multiplying the share price of a stock times its ADTV

ADV = ADTV * Share Price

For example, a $25 stock with an ADTV of 800,000 shares has an ADV=20 million ($25 x 800,000). If a $100 stock has an ADTV of just 200,000 shares, it would be the same ADV=20 million ($100 x 200,000). It appears that both the $25 and $100 stocks to have equal liquidity. Thus, ADV is a more important measure than ADTV. If you trade a rather large account, then consider an AVD > 80 million to ensure plenty of liquidity.