At its most basic level, the liquidity of an investment defines the ability of a trader to convert a large quantity of the asset into cash at a low cost and with little price impact (Pastor and Stambaugh, 2003). The more liquid an asset, the cheaper it is to trade. All other things being equal, an investor would prefer a liquid to an illiquid asset, especially if the expected holding period is short.
The average cost to trade varies by type of security and timing of the transaction. The basic cost structure is familiar. At one end of the spectrum, trading benchmark US Treasury notes costs little per notional; at the other, moving a large portion of small-cap emerging market securities in the after-market is very expensive. For a very popular (i.e., mid-spectrum) market, Aked and Moroz (2015) found in their internal empirical analysis that a small lot of listed US equity securities cost, on average, 3% for each block of average daily volume. Therefore, to trade 10% of the daily volume of a security, the costs to execute, on average, should be about 0.3%.
Most asset classes—stocks, bonds, currencies, commodities, and derivatives, among others—are viewed as trading frequently, and therefore as being liquid. The illiquid designation is generally reserved for assets such as real estate, timber, art, private equity, and hedge funds that trade less frequently and not on an organized exchange. The liquid–illiquid classification is based on average trading costs over time. As we’ve shown, however, the cost of trading is not fixed. During times of economic stability and abundant financial opportunities attracting liquidity providers is easy, whereas at times of greater uncertainty, finding liquidity providers is difficult. When liquidity is scarce, the cost to trade rises as does the opportunity to profit, sometimes significantly.