Thoughts on measuring liquidity

Liquidity is a notoriously ill-defined concept.  On the stock market I think liquidity should be defined as the ease with which you are able to sell your holding at (that is without causing a decline in) current prices.  The most important measure of liquidity is then likely to be the demand for your position at current prices.  An important contrary indicator would be supply of your position at current prices.

Thus I propose that the SEC use as one measure of daily stock market liquidity for each stock:  the dollar value of purchases that resulted in an end of day increase in the buyers’ holdings of the stock.  An important related measure would be reverse liquidity or the dollar value of sales that resulted in an end of day decrease in the sellers’ holdings of the stock.  To keep the definition of the entities trading in the market from being gamed, the SEC would probably have to track these trades using something like the entity’s tax ID number.

These measures of liquidity would have the benefit of ignoring day traders and other trend followers that do little or nothing to ensure that the market is robust at current prices.

It is true that the end of day measure is chosen at random and thus that it would make sense separate hourly, daily, weekly, monthly and annual measures of liquidity.

Another advantage for the SEC of collecting comprehensive data on the trades of investors with a longer-term horizon is that the SEC would have the information necessary to assess whether current market practices impose a tax on long horizon investors by causing them to buy at higher prices and sell at lower prices than the noise traders.


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