Market makers, and where liquidity actually comes from
The answer
Liquidity is how easily you can buy or sell without moving the price. It is not a fixed property of a stock. It is a service, provided by people who choose to provide it, and they stop providing it exactly when conditions get frightening.
Why this costs you money
Everybody plans the entry. Almost nobody plans the exit.
You buy a small company. It trades every day. The price appears on your screen every second. It feels as available as any other stock, because the screen makes everything look the same.
Then something goes wrong — bad results, a sector scare, a market-wide fall — and you decide to sell. And you find there is nobody there. The bids that were on your screen all month were 200 shares deep. You hold 8,000.
This is the difference between being wrong and being trapped. Being wrong costs you what you expected to lose. Being trapped costs you far more, because you sell over 5 days into a falling market, each sale pushing the price down for the next one.
The specific mistake is this: people size a position by how much they like it, not by how quickly they could get out of it. The second question takes 30 seconds to answer and nobody asks it.
How it works
Somebody has to be on the other side of your trade. There are only 4 possibilities.
- Another investor who happens to want the opposite of what you want, at the same moment, in the same size. This is rare.
- A market maker — a firm that quotes both a buy price and a sell price continuously, and earns the spread between them.
- An arbitrageur who is taking the other side because it fits against a position somewhere else, often in a related instrument.
- Nobody. This is a real answer, and it is the one this article exists for.
A market maker is not doing you a favour. They quote a price to buy at 248.50 and to sell at 248.60, and if both sides trade they keep 10 paise having taken no view on the company at all. Their risk is inventory — being left holding something while the price runs away from them.
That single fact explains their entire behaviour.
| When | What a market maker does | What you see |
|---|---|---|
| Calm, normal day | Quotes tight, both sides, decent size | Narrow spread, deep book |
| News is due | Widens the spread, cuts the size | Spread doubles before results |
| Sudden shock | Withdraws, or quotes at absurd prices | The book looks empty |
Liquidity is therefore pro-cyclical. It is abundant when you do not need it and scarce when you do. Any plan that assumes you can exit at the screen price in a crisis is assuming the one thing that is never true in a crisis.
Liquidity also moves through the day. Volume in most markets follows a U shape — heavy at the open, thin in the middle, heavy at the close. A thin stock in the middle of the afternoon may not trade at all for 20 minutes.
What it tells you, and what it does not
Daily volume tells you roughly how much can change hands without a fuss. It is the single most useful liquidity number available to a retail investor and it is free on every app.
It does not tell you the depth at this instant, and it does not survive a regime change. A stock that traded 10 lakh shares a day all year can trade 40,000 on the day everybody wants out, because the volume was never a promise.
And high volume is not automatically real liquidity. A stock can show enormous volume from a handful of participants trading with each other, and still have nothing behind the bid when you arrive with a real order.
The decision rule
Size your position against volume, not against conviction.
Before you buy, find the average daily volume. Then ask: what percentage of one day's volume is my whole position?
- Under 5% — you can exit in a day without being noticed.
- 5% to 20% — you need 2 or 3 days, and you will move the price.
- Over 20% — you do not have a position, you have a commitment. Assume you
cannot exit in a bad week at any price you would accept.
Then apply the haircut that professionals apply automatically: assume liquidity halves when you need it. If exiting takes 2 normal days, plan for 4 bad ones.
Try this now
Sixty seconds, and it is the question almost no retail investor asks.
- Open your smallest or least-known holding.
- Find the average daily volume — most apps show volume under the chart, or list "Avg Volume" in the stock's key statistics. Use a 1-month or 3-month average, not today's number.
- Take the number of shares you hold.
- Divide your holding by the average daily volume. Multiply by 100.
What you should see. For a large company it will be a fraction of a percent, and you can stop worrying. For a genuinely small one it may be 10%, 30%, or more — and that number is how many days of the entire market's trading in that stock you personally represent.
Now do the same calculation for the position you were thinking of adding to. That is the decision this article is for.
Three real cases
1. Franklin Templeton India, April 2020 — the exit closed Six debt mutual fund schemes were wound up because the funds could not sell their bonds fast enough to meet redemptions. Investors could not withdraw their money. The bonds still existed and had a value, but there was no buyer at any sensible price. Money was returned over the following years. The assets were never the problem — the ability to convert them into cash on demand was, and that ability had never been guaranteed.
2. Bond ETFs, March 2020 (United States) — the price left the value As the pandemic panic hit, several bond ETFs traded at meaningful discounts to the calculated value of the bonds they held. The mechanism that normally keeps the two together relies on firms being willing to step in and arbitrage the gap. For a period, they were not willing at any normal size. The ETF was not broken. The people who make it work had stepped back.
3. The Flash Crash, 6 May 2010 (United States) — everyone left at once The official report describes liquidity providers withdrawing within minutes as uncertainty spiked, leaving order books so thin that trades executed at nonsensical prices before recovering. The instruments involved were among the most liquid in the world that morning. Liquidity is a state, not a feature.
The question that resolves it
A novice asks: how much do I want to own?
An expert asks: how many days would it take me to get out, on a bad day?
The second question is the one that turns a position size from a feeling into a number.
What would make this wrong
If liquidity were a fixed property of a stock, then spreads and depth would look the same in March 2020 as in a calm month. They did not, in any market, for any asset class.
The honest limits.
For a genuine long-term investor with no forced exit, illiquidity is not a risk — it is a discount you are being paid to accept. Some of the best returns in markets have come from things nobody could trade easily. The risk is not illiquidity itself. It is illiquidity plus a reason you must sell: borrowed money, a margin call, a school fee due in March, or a stop-loss you promised yourself you would honour.
And liquidity is not free. Somebody is paid to provide it, through the spread. A market with no market makers has no spread to pay and no depth to rely on. You choose which cost you prefer; you do not get to avoid both.
In India
Indian cash equities have no designated market makers. There is no firm under any obligation to quote a two-sided price in an ordinary listed company. When a small-cap has no buyers, the book is simply empty. This is the single most important structural fact about Indian small-cap investing and it is barely discussed.
Market makers do exist in 3 specific places:
- ETFs, where appointed participants keep the traded price near the value of the underlying holdings.
- The SME platforms of the NSE and BSE, where market making is mandatory for a period after listing.
- Parts of the derivatives market, supported at times by SEBI's liquidity enhancement schemes, which pay incentives to firms that quote in contracts that would otherwise be dead.
Two Indian mechanics amplify the problem. Price bands mean a falling small-cap can hit its lower limit with no trades at all — the screen shows a price nobody can transact at. And in derivatives, liquidity concentrates overwhelmingly in the nearest expiry and a handful of strikes; everything else is thin no matter how liquid the index looks.
In the United States
Listed shares have designated market makers with quoting obligations, and a large ecosystem of electronic firms that make markets voluntarily because it is profitable. Between them, spreads in even medium-sized US companies stay narrow in normal conditions.
Retail orders often never reach an exchange at all. Brokers route them to wholesalers, who fill them internally — usually at a price slightly better than the public quote. This is why a US retail investor experiences excellent liquidity in stocks whose displayed order books look thin.
The obligations, however, are weaker than they sound. A designated market maker must quote, but the rules on how far from the market they may quote leave a great deal of room. In a genuine panic, "quoting" and "providing liquidity" are not the same thing.
Where they differ, and what that tells you
In the United States, somebody is contractually on the hook to quote in a listed stock. In India, in the cash market, nobody is.
What that tells you is how differently the same strategy behaves in the 2 countries. An American investor holding a mid-cap has a reasonable expectation that a two-sided market will exist tomorrow. An Indian investor holding a small-cap depends entirely on other investors wanting that same stock tomorrow.
That is why Indian small-cap liquidity is so closely tied to sentiment. In a strong market, volumes are enormous and everything looks tradeable. In a downturn, the same stocks go days with almost nothing changing hands. The liquidity was never independent of the mood, because there was no one whose job it was to make it so.
The practical instruction for an Indian investor is therefore stricter than the imported version: measure your position against average daily volume, and then assume that volume was borrowed from a good mood.
Carry this
- Liquidity is a service, not a property. It is withdrawn when it is needed.
- Your position ÷ average daily volume = the only position-size number that matters in a small company.
- Assume liquidity halves on the day you want out.
- The screen price is a record of the past, not an offer to you.