Liquidity and Volume: Why They Decide What You Can Trade

Sam's Friday chart from the last lesson ended on a strange screen. He'd flipped from XYZ to a small stock called ABCD and found almost no volumeVolumeVolume is the total number of shares (or contracts) traded during a given time period — it's the primary confirmation tool for all price action, because a price move accompanied by high volume indicates genuine market participation, while tRead definition → bars, prices jumping 15 cents at a time, and a 12-cent difference between the best price to buy and the best price to sell.

ABCD was up 22% on the day. Part of him wanted in. The other part had a question he couldn't answer yet: if he bought it, who would he sell it to?

That question is what this lesson is about. Before any candle, level, pattern or indicator matters, one thing decides whether a stock is even worth looking at. Is anyone actually trading it, and can you get in and out at a fair price?

In this lesson you'll learn what liquidity and volume mean, why they aren't the same thing, how to check a stock in five quick steps, and why thin stocks are a trap for beginners. If you're new, start with Lesson 24: Basic Indicators, where Sam kept volume bars on his chart.

Liquidity is how easily and quickly you can buy or sell a stock without pushing its price against you. The SEC's investor education site defines it as how easily or quickly a security can be bought or sold in the market (Investor.gov).

Think about selling an iPhone versus selling a house. Post a recent iPhone at a fair price and it's gone in an hour, close to what you asked. A house can sit for months, and if you need the money this week, you'll have to cut the price hard. Same seller, very different liquidity.

Stocks work the same way. In a liquid stock, lots of buyers and sellers are waiting at prices a cent or two apart, so your order fills fast and close to the price on your screen. In an illiquid (or "thin") stock, few people are waiting, prices sit far apart, and your own order can move the price.

You can't see liquidity as one number, but you can see three signs of it:

So liquidity is really about one thing: what it costs you to get in and get out. Which raises the obvious question about the bars at the bottom of every chart.

Trading volume is the number of shares that change hands during a period, such as one minute, five minutes or a full day. When a seller sells 100 shares to a buyer, volume rises by 100. It doesn't double, because the buyer and seller are two sides of the same 100 shares.

On a chart, each volume bar shows the shares traded during that candle. Sam already has these under his 5-minute chart from Lesson 24. Tall bars mean busy minutes. Short bars mean quiet ones.

Three volume numbers matter for checking a stock:

Average periods vary by platform; many show the last 30 or so trading days.

Dollar volume is the one beginners miss. Three million shares of a $1 stock is $3 million changing hands. Two hundred thousand shares of a $50 stock is $10 million. The second stock trades fewer shares but far more money. Researchers use the same idea: Yakov Amihud's widely used illiquidity measure compares a stock's daily price move with its dollar volume, so a stock that moves a lot on little money counts as illiquid (Amihud, 2002).

Comparing today's volume with normal has a name, relative volume, and it gets its own lesson in Lesson 40: Relative Volume. Reading what volume bars say about buyers versus sellers is Lesson 29: Volume Analysis.

No. Volume measures how much trading happened; liquidity measures how easily you can trade without moving the price. High volume usually comes with good liquidity, because more traders means more competition on price, but one doesn't guarantee the other.

Picture a highway. Volume is the traffic count: how many cars passed today. Liquidity is whether you can merge, change lanes and take your exit without slamming the brakes. A busy, well-built highway has both. A road where every car is suddenly heading the same way has plenty of traffic and no room to move.

Markets have shown this in public. On May 6, 2010, US stocks and futures crashed and rebounded within minutes. The joint CFTC and SEC staff report found that trading volume surged while buy-side depth in the main S&P 500 futures contract fell to under 1% of its morning level, and it concluded that high volume isn't necessarily a reliable sign of liquidity (CFTC-SEC, 2010). Some stocks traded for a penny, and exchanges later canceled trades that printed far from their earlier prices.

Research says the same in calmer times. A study in the Journal of Financial Economics found that volume and liquidity are connected but behave differently, and that heavy volume can come with higher liquidity risk (Johnson, 2008).

Volume tells you how busy the road is. Liquidity tells you whether you can get off it.

That's why you check both, every time. Here's how.

You check a stock's liquidity with five quick questions: what its normal volume is, how busy it is today, how wide the spread is, how big your order is next to the shares available, and what time it is. It takes under a minute, and you do it before you look for an entry.

If the stock fails any one of these for your size, the answer is to skip it, however good the chart looks.