When talking about exchange traded funds (ETFs), we often refer to liquidity. But what does that mean?

When you purchase a stock or ETF, the seller’s ask price for the stock and the buyer’s bid price are typically only a few pennies off from each other. This means that the purchase occurred close to the market price. This narrow "bid-ask spread" is an example of liquidity, says Matt Ford for Minyanville. According to the Congressional Budget Office, the actual definition of liquidity is:

"The ease with which an asset can be sold for cash. An asset is highly liquid if it comes in standard units that are traded daily in large amounts by many buyers and sellers. Among the most liquid of assets are U.S. Treasury securities."

Perhaps a better way of understanding liquidity is looking at what’s not liquid. For example, real estate is an investment that is considered illiquid. Homeowners know that if they decide to sell their house, it will probably take a long time and lots of negotiations before the sale is completed. The recent housing slump is an excellent example of this. Recently, there has been a very large gap between the seller’s ask price and the buyer’s bid price. This has caused home sales to drop throughout the country. A good rule to go by is: The wider the bid-ask spread, the less liquid the market.

You might have heard about the Federal Reserve’s recent injection of liquidity into the U.S. banking systems. During market panics, such as the subprime crisis, bid-ask spreads often widen as buyers are reluctant to buy, which puts a halt on liquidity. The Fed usually responds by adding money and credit to the markets to rejuvenate liquidity. However, this is usually looked at as a last resort because Fed injections can lead to bubbles in the markets.

Tags: Federal Reserve