Market Liquidity and Price Impact: Why Selling a Large Position Moves the Price
Market liquidity is the ability to buy or sell an asset quickly without causing a large change in its price. Liquid assets trade at tight bid-ask spreads with minimal price disruption; illiquid assets must be discounted to sell fast. Selling a large position concentrated in time causes price impact, meaning the realized price falls well below the quoted price.
Market liquidity is the feature of a market whereby a buyer or seller can transact quickly without causing a drastic change in the asset's price. The core trade-off is speed versus price: in a liquid market you can sell rapidly at close to the quoted price, while in an illiquid market a quick sale requires a significant discount. Market depth is a related but distinct concept. Depth concerns the quantity-versus-price trade-off, that is, how much volume the order book can absorb before the price moves, whereas liquidity concerns the speed-versus-price trade-off for a transaction of any size. The bid-ask spread is a common liquidity gauge. For highly liquid stocks the spread can be a few cents, far less than 1% of the price; for illiquid securities it can be several percent of the trading price. When a seller pushes a large position onto the market in a short window, available buyers are exhausted and the price falls, an effect called price impact or slippage. The price actually realized for a large block is therefore below the quoted or 'marketable' price, and the gap widens the larger and faster the sale. This is why a holder of a very large stake cannot convert their position to cash at the headline valuation, a point developed in Why Market Cap Can't Buy a Country: Paper Valuations vs. Physical Asset Value and related to the Greater Fool Theory: When Asset Prices Depend Entirely on Finding the Next Buyer.