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The Capital Market and Its Players — Market Liquidity, Explained
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Market Liquidity, Explained

Market Liquidity

The three key characteristics used to describe market liquidity are depth, breadth, and resiliency.

Depth of the market, also known as DOM or order book, represents the number of open buy and sell orders for a particular security at different prices. A secondary market is said to have depth if there are orders both above and below the price at which the stock is currently trading.

Depth is primarily a measure of the supply and demand for a particular security. It also refers to the number of shares of a particular stock that can be bought without having an impact on the stock price. Depth allows markets to offset temporary imbalances of buy or sale orders that would otherwise lead to substantial changes in the stock’s price. Investors can also use depth of the market data to make educated predictions about the future movements of stock prices.

Take for example: a stock might currently be trading at $1.00, but there may also be offers at $1.10 and offers at $0.90. If there are more offers at prices higher than the current trading price, traders may assume that the market pricing for the stock is going higher. Conversely, if there are more offers at prices lower than the current trading price, this may be a sign that the price is going to go down soon. Armed with this information, traders can decide whether or not the time is right to buy, sell or hold the stock.

Breadth of the market represents the percentage of stocks that participate in a particular market’s move.

For example, let’s take the S&P 500 index listing 500 stocks. If the index is rising on a particular day and 450 (90%) of the 500 stocks are going up in price, the market is said to have a very good breadth. On the other hand, say the S&P 500 is rising, but only 100 out of the 500 stocks show growth. This would mean that the rise is driven only by a small number of large stocks and the market breadth is small.

In traditional technical analysis, which we'll speak about in our further chapters, high market breadth is believed to confirm a market trend. For example, if the stock market is falling and the majority of individual stocks in that market also record losses for the day, this would be a strong sign that the market will continue going down. Conversely, if only some of the individual stocks record losses, this would indicate that the market might turn upwards soon, as there's no foundation for a downtrend.

The broader the market for a stock, the more likely it is to stabilize any temporary price changes arising order imbalances.

Resiliency of the market gauges its ability to quickly respond to temporary pricing errors and imbalances in order flows. Resiliency can be described as the speed at which prices return to their former levels after a shock caused by large, aggressive orders. It can also be described as a feature of the market in which new orders flow quickly to correct liquidity of the market after such shocks.

To summarize, resiliency describes the speed at which any pricing errors and order flow imbalances can be eliminated through the transactions of market participants. If new orders flow quickly and the prices bounce back, the market is seen as resilient and well-functional.

The stock market is considered to be very liquid. Think of the major stock exchanges such as the NYSE or the NASDAQ, where millions of shares change hands across millions of buyers and sellers every day.