When it all goes pear shaped
If the market for a stock becomes illiquid, that means that there are not a lot of buyers or sellers and if one or both of those parties no longer participate the market becomes frozen and/or crashes. Remember that markets determine what things are worth, and if you can’t determine what something is worth, you can’t determine what you are worth (in monetary terms).
This is the exact issue that arose during the recent financial crash. Many banks had assets (mortgages) that the market disappeared for, thereby making virtually impossible to calculate what those assets, and therefore anyone who held those assets, were worth. If nobody knows how much the holder of those assets is worth, then it is very hard to justify being an investor because you just don’t know what you’re buying into. Recall that as uncertainty (or disagreement between buyers and sellers) increases, the spread between buyers and sellers will become much wider.
It is a scary prospect if you are on the wrong end of one of those moments where the market for a given stock goes sharply in one direction or another. The fewer the participants trading a particular stock the more likely that stock’s price will fluctuate more wildly.
Coming up next
In the next article in this series, we will talk about how great traders approach market fluctuations. For now though, it is important to understand that prices are reflections of opinions and beliefs. Each participant, buyer or seller, has an opinion about what a stock should be worth at some point in the future and it is that belief that (generally) drives their purchase or sale of a stock. Sometimes those opinions are correct and sometimes they are not, and great traders are the ones who can consistently figure out the difference.