What is ETF liquidity?

ETFs are great investment vehicles for the everyday person not wanting to invest directly in individual stocks because they enable one to invest into an entire index, such as the S& P 500 or Dow Jones Industrial Average.

 

This popularity has led many people to wonder how these funds work and the benefits of investing through them instead of investing in stocks. One fascinating question is what “ETF liquidity” means and why it’s essential to know about it before deciding whether or not you want to invest in ETFs.

What is Liquidity used for?

Liquidity measures how much value can be bought and sold without affecting its price. For example, if you remove all the gold from Fort Knox, how much effect would this have on its price?

 

Not very much at all. It’s because gold is quite liquid in that it can be easily bought or sold without affecting its price too significantly. Conversely, if you removed all the water from Long Island Sound, how much would this affect its market price? A tremendous amount! It’s because water is not at all liquid.

 

Liquidity itself can be looked at in two ways, either regarding market depth or order book depth. Market depth refers to the availability of shares available for purchase or sale on a specific exchange. In contrast, order book depth refers to the availability of orders within a specific range of prices across exchanges. Let’s discuss both types of liquidity and how they apply to ETFs.

Market depth

The first measure of market depth is the ratio between the number of shares available for sale and the value those shares represent, called the “top-down” approach. It’s important because if more shares are available at a specific price, it’s easier to buy or sell as fewer buyers (or sellers) will be needed to make up for those trying to buy (sell) at that price.

 

For example, let’s say there are 100 shares available at $50 per share on an exchange with 10 million total shares outstanding across all companies represented by this ETF. That ratio would be one share per $5,000 worth of this ETF’s assets divided by 10 million total shares outstanding.

 

However, if there are only 50 shares available at $50 per share on this same exchange, that ratio would be two shares per $5,000 worth of this ETF’s assets divided by 10 million total shares outstanding. That means it is twice as hard for you to buy or sell one or two units of the ETF as before due to the lack of liquidity in the market depth.

Top-down

The second measure of market depth is “top-down”, as the first measure except it instead takes into account order book depth (minimum price someone will pay for an asset) rather than market depth (amount available at a specific price). It tells how many people are willing to buy up to a certain level below the current market price.

 

For example, if there are 100 shares available at $90 per share and ten people willing to buy up to $80 per share, the market depth will be 1/10th of a share per $1,000 worth of this ETF’s assets. However, if only nine people are willing to buy up to $80 per share or less, the market depth will appear as 1/9th a share per $1,000 worth of this ETF’s assets.

 

It’s crucial because, in periods where many individuals want to sell an asset quickly, the price may go down very fast because there aren’t enough shares offered for sale by those wanting to take their time in selling.

Order book depth

Order book depth refers to the availability of orders within a specific range of prices across exchanges. It’s crucial because it tells you how many people are willing to sell an asset for different prices (up to a certain level) and how much they want for each price.

 

For example, if there are 30 shares available at $80 per share, ten shares available at $84 per share, and 20 shares available at $90 per share, the order book depth will be 1/10th, 1/20th, and 2/30ths a share for those respective prices.