Illiquidity describes when a trader is unable to trade an [instrument] in the market in a straightforward manner. The primary cause of illiquidity is a lack of supply and demand for the instrument which indicates a possible lack of traders.
An instrument may have opened trading with [liquidity], but news events throughout the trading day can drive demand away from the market, leaving it in an illiquid status by the end of the day. If a trader owns an illiquid instrument, they might have to suffer a loss in order to rid themselves of the instrument if they are uncertain when or if it will be able to recover from that status.
In an illiquid market born of a lack of buying and selling traders, there will often be a large discrepancy in the [ask] and [bid] prices of the instrument. This will lead to a much larger bid-ask spread than is normally found in liquid markets. Due to this lack of market depth, holders of illiquid instruments will often suffer losses, especially if they are seeking to sell the instruments quickly.
In the case of illiquid stocks, they will often have a liquidity premium reflected in their price due to the fact that they may be harder to offload in the future. This is especially true in times of market uncertainty when the ratio of traders desiring to enter the market will usually be far outweighed by traders seeking to exit, and therefore, holders of illiquid assets will find it very hard to dispose of these at a good price, if at all.
Key takeaways:
- An illiquid asset is a financial instrument that cannot easily be traded
- Illiquidity is commonly caused by a lack of traders or a lack of volume demand for an instrument
- Instruments may originally trade with liquidity but due to market and news events, may in the future become illiquid
- Holders of illiquid stocks may have to dispose of these at a loss if they wish to dispose of them quickly