Why Liquidity Matters: Analysing Trading Volume and Market Depth

Defining Liquidity in Equity Markets

In the context of stock markets, liquidity refers to the ease with which shares can be bought or sold at or near the current quoted price, without the transaction itself causing significant price movement. A highly liquid stock allows large positions to be accumulated or exited quickly with minimal market impact. An illiquid stock may require days or weeks to trade meaningful size, with each transaction pushing the price further from your intended entry or exit point.

Liquidity is not a single metric but a multi-dimensional concept. It encompasses volume (how many shares trade daily), depth (the size of resting orders at various price levels), spread (the gap between bid and ask prices), and resilience (how quickly the order book replenishes after a large trade).

Why Liquidity Matters for Investment Returns

Academic research has consistently documented a liquidity premium in equity markets. Less liquid stocks tend to deliver higher returns over time, compensating investors for the additional costs and risks of trading them. Amihud (2002) demonstrated that expected illiquidity positively affects expected stock returns in a study spanning 1964-1997, and subsequent research has confirmed this finding across international markets.

However, the relationship between liquidity and returns is more nuanced than simply "buy illiquid stocks." Several mechanisms make liquidity critically important:

Transaction Cost Drag

Every stock transaction involves costs beyond the headline brokerage commission. The bid-ask spread represents a direct cost of round-trip trading. For liquid FTSE 100 stocks, spreads typically range from 0.02-0.10% of share price. For less liquid FTSE 250 or AIM stocks, spreads can exceed 1-2% or more.

For a buy-and-hold investor trading once, this cost is relatively minor. But for investors who rebalance quarterly, respond to factor score changes, or employ strategies with higher turnover, accumulated transaction costs can significantly erode theoretical returns. A strategy that backtests at 12% annual return but generates 400% annual turnover in illiquid names may deliver substantially less after realistic trading costs.

Market Impact

Beyond the quoted spread, large orders in illiquid stocks create market impact - the price moves against you as you trade. If you want to buy 50,000 shares of a stock that normally trades 20,000 per day, you cannot simply place a market order. Your buying pressure will exhaust available liquidity at the current price and push the stock higher, meaning you pay progressively more for each share.

This effect is particularly damaging because it is asymmetric. When you want to buy, you push the price up. When you want to sell (perhaps urgently during a market correction), you push the price down. The illiquidity premium compensates for this unfavourable asymmetry, but only investors who genuinely hold through complete market cycles capture it.

Liquidity Risk During Market Stress

Perhaps most importantly, liquidity is not constant. It evaporates precisely when you need it most - during market panics, sharp corrections, or company-specific crises. A stock that trades smoothly during calm markets may see its bid-ask spread widen by 5-10x during stress events as market makers withdraw and natural buyers disappear.

This liquidity-in-crisis dynamic means that illiquid positions can become trapped positions during exactly the market conditions that create the strongest motivation to sell. Factor models that ignore liquidity may rank fundamentally attractive but practically untradeable stocks highly, leading to portfolios that look excellent on paper but perform poorly in practice.

Measuring Liquidity

Our model uses multiple metrics to construct the liquidity factor score, each capturing a different dimension:

Average Daily Volume (ADV)

The simplest and most widely used liquidity measure. We calculate ADV over both 20-day (short-term) and 90-day (medium-term) windows to capture both current trading activity and typical liquidity conditions. Stocks where recent volume has spiked above historical norms may be experiencing unusual activity (news events, block trades) rather than genuinely improved liquidity.

Turnover Ratio

Average daily volume divided by shares outstanding. This normalises volume for company size - 100,000 shares traded daily represents vastly different liquidity for a 10-million-share company versus a 1-billion-share company. Higher turnover ratios indicate more active trading relative to the float, suggesting broader investor interest and more efficient price discovery.

Market Capitalisation as Proxy

While not a direct liquidity measure, market capitalisation correlates strongly with institutional coverage, analyst following, and market-maker commitment. Larger companies attract more participants, creating deeper order books and tighter spreads. We include market cap as a liquidity signal because it captures the structural liquidity advantages that size confers.

Free Float Percentage

The proportion of shares available for trading (excluding locked-in holdings by founders, governments, or strategic investors). A company with large market cap but only 20% free float may be much less liquid than its size suggests, because 80% of shares never appear in the market.

Liquidity and the Other Six Factors

Liquidity interacts with other factor scores in important ways that investors should understand:

Liquidity and Value: Many deep value stocks (very low P/E, high dividend yield) are cheap precisely because they are illiquid. Small institutional investors cannot take meaningful positions, reducing demand and depressing prices. The liquidity factor helps distinguish genuine value opportunities (cheap AND liquid) from value traps (cheap BECAUSE illiquid).

Liquidity and Technical: Technical signals are more reliable in liquid stocks where price discovery is efficient. A breakout pattern in an illiquid stock may simply reflect a single large buyer rather than genuine momentum. Our model implicitly adjusts for this by scoring both factors independently.

Liquidity and Solvency: Companies approaching financial distress often see liquidity collapse as investors flee and market makers widen spreads. Declining liquidity can be an early warning signal of fundamental problems, which is why we include both factors rather than choosing between them.

Practical Implications for Portfolio Construction

When using the Strategyland screener, the liquidity factor weight should reflect your portfolio size and trading style:

Larger portfolios (above 100,000 GBP): Consider increasing the liquidity weight to 20-25%. Market impact becomes material when your position size approaches a significant fraction of daily volume. Ensuring high liquidity scores means you can enter and exit positions without moving markets against yourself.

Smaller portfolios (below 50,000 GBP): You may reduce liquidity weight to 10% or even 5% if you are comfortable with longer holding periods. Smaller positions create negligible market impact even in moderately liquid stocks, allowing you to capture the illiquidity premium without suffering its costs.

Short-term traders: Maximise liquidity weight (25-30%). When you need to react quickly to market conditions, liquidity is your primary concern. A fundamentally perfect stock that you cannot trade quickly enough is useless for short-term strategies.

The Liquidity-Return Trade-off

Like all factor premiums, the liquidity premium involves a genuine trade-off. Highly liquid stocks are easy to trade but tend to be efficiently priced with less room for alpha generation. Less liquid stocks offer higher expected returns but are harder to trade and more vulnerable during stress.

The optimal approach for most investors is to set a minimum liquidity threshold (using the factor weight) that ensures practical tradability, then allow the other six factors to determine ranking within that liquid subset. This captures the benefits of multi-factor screening while avoiding the practical pitfalls of illiquidity.

The Strategyland default of 15% liquidity weight achieves this balance for most individual investors managing portfolios in the 10,000-500,000 GBP range. It provides meaningful liquidity filtering without eliminating the smaller, potentially more rewarding companies from consideration.