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Liquidity risk

The risk that you cannot exit at a reasonable price because there are no buyers at the size you need, when you need them.

Liquidity is not a property of an instrument, it is a property of an instrument at a size in a moment. A stock trading 400,000 shares a day is liquid for 2,000 shares and illiquid for 80,000; the same stock is illiquid for 2,000 shares in the first minute after a halt.

Estimate it before entry with a simple rule: position size should be a small fraction - often under 1% - of average daily volume, and the bid-ask-spread you can currently see should be multiplied by three to four for the exit you might actually need. In options, check open-interest and the width of the market away from the front strikes; in crypto, check depth on the book rather than headline volume.

Liquidity risk compounds every other risk. It turns a stop into a stop-slippage event, a margin shortfall into forced-liquidation, and a diversified book into a single correlated position when everyone exits at once.

Related: stop-slippage, forced-liquidation, liquidity, correlation-breakdown

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Bid-ask spread in an order bookSell orders stacked above buy orders with a gap between the best of each.SELLERS (asks)50.0690050.051,40050.0460050.011,10050.002,30049.99800spread = 0.03BUYERS (bids)
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.
Slippage on a market orderA buy order clears four price levels, so the average price paid is worse than the price first quoted.Buy 1,000 shares at marketpricesell orders resting (bar length = size)20.04300 shares20.03200 shares20.01200 shares20.00300 sharesnothing resting at 20.02order sweeps up the bookaverage fill 20.02SLIPPAGE0.02 a share$20.00 in totalintended 20.00Each level fills at its own price; the average is what you really paid.
Slippage on a market order. You click at 20.00, but only 300 shares are resting there, so the rest of the order fills at 20.01, 20.03 and 20.04. The average price paid is 20.02, and that two-cent gap is slippage.

Educational only, not advice. Spotted an error? Post in Site Feedback.