Some investors will suggest that short-term market traders can help to over exaggerate price movements on the upside and the downside. This may well be correct because sustained buying or sustained selling of a relatively small company can impact the share price no matter what is going on behind-the-scenes. Well at least in the short term!
Liquidity is the key
If we were to ask you about the liquidity of stock markets around the world and individual shares, where would you suggest this came from? Does it come from passive investors who buy stock and sit on it for years to come? Do institutions regularly buy and sell stocks to bank relatively small profits in a similar fashion to day traders? The fact is that day traders and speculators offer a vital service to any stock market, namely liquidity.
Why is liquidity so important?
If we give you two examples where liquidity is very different but just as important, you will begin to understand what it is all about. If you have $1 million and you decide to buy a property it may take some time to finish the deal but you can have the property under your control in a relatively short space of time. If you are buying $1 million worth of shares then the liquidity created by speculators and traders often means that you will be able to fulfil your transactions almost immediately. There may be cases where you need to slowly build up a relatively large position in a smaller company but on the whole companies listed on the stock market do not often have liquidity issues.
The problem occurs if you need to cash in your $1 million portfolio, of shares or property, because property is relatively illiquid and you may not be able to close the deal at the right price in your preferred timescale. On the whole, as long as there are no major issues with the company’s in which you are invested, you should be able to begin selling down your portfolio almost immediately. To get the best prices you may need to work on this over a few days but the liquidity in the stock market bears no resemblance to that in property markets for example.
Overbought and oversold positions
Again, as we have touched on in some of our earlier articles, very often shares will move to overbought and oversold positions because of “over exuberance”. Many long-term investors will complain about volatile share price movements but eventually overbought positions will ultimately balance out. If you think of the stock market as an “information exchange” if more and more people believe a share price is overbought then they will short/sell the stock bringing it back down to “fair value”.
If on the other hand a share price is oversold then buyers will eventually emerge, short-term traders, speculators and long term investors, and the price will at some point return to a “fair value”. These are just some examples of how day traders and relatively short-term investors help to oil the wheels of any stock market (indeed any investment market). Liquidity is vital because you could have shares in the best company in the world but if there is no liquid market, and you are not able to sell your shares, what are they really worth?