How is Liquidity Measured?

This is the third part of my miniseries on liquidity.  Start with What is Liquidity? and What Determines Liquidity?.

As I discussed in those posts, how much the price of a good moves when people buy and sell it is one way to measure the liquidity of that good in the market.  This can be observed in a formal art auction easily, but can also be observed in other markets, like the example of gasoline.

The stock market has liquidity measures that are easy to observe.  The stock market is an ongoing auction with many buyers and many sellers.  Each stock is very fungible (one share of Apple's stock is the same as another), so that prerequisite for liquidity is achieved.  Some companies have more shares of stock in the market available for trade, which increases the potential liquidity.  This is why you might hear people talk about how one company's stock is more liquid than another.  For example, consider Dell (with 1.96 billion shares) and Super Micro Computer (with 35.9 million shares).  Dell's stock is potentially more liquid than Super Micro Computer's stock.  Note: this is different than a business' internal liquidity, which is related to how much cash they have on hand, a topic for a different post.

If you wanted to put the effort in, you could watch each trade for a stock as they happened and measure how much the price changed.  There is an easier way for many stocks:

Look at this detailed quote of Google on Yahoo Finance.  Check out the numbers for the Bid and the Ask.  The Bid is the highest latest price someone has offered to buy the stock, and the Ask is the lowest latest price someone has offered to sell the stock.  The difference between these two numbers is a measure of liquidity.  The closer these two numbers are, the more liquid the stock.  You can imagine, that if these two numbers were always the same, people would buy and sell the stock freely and the price would never change.  That is the definition of perfect liquidity.

What actually happens, though, is a buyer decides that the seller's Ask is good enough (or vice versa), and a trade is made.  The latest price for the stock is set to that trade's price, and the next lowest seller's offer becomes the new Ask.  The farther apart the Bid and Ask are, two things happen: it is less likely for someone to decide that an offer is good enough to make a trade, and when that trade does happen the price moves more.  In other words, lower liquidity.