Liquidity describes a market’s price sensitivity:

1. A liquid market will have relatively small price changes in response to large orders.
2. A trader who executes a large order in an illiquid market can cause price to change significantly, however the effect is usually temporary.

Liquidity describes the markets ability to absorb large orders without substantially affecting price. A liquid market has small price changes in response to orders. The fundamental supply and demand factors can generate the need for a vehicle that allows users and producers to offset their risk. Speculative trading provides much of the liquidity futures contracts and smoother price activity for the commercial user.

Research shows the presence of speculators leads to more liquid markets. Speculators absorb all sorts of market events, so that an increase in speculation means that these shocks are distributed among more traders, diminishing excessive price volatility.

A trader who demands immediate execution of a large trade in an illiquid market may cause price to move significantly. For example, an order to buy a significant quantity of a grain may cause the price to move. If the current price for wheat is $7.44 a bushel, and an order is entered to buy 1000 bushels at the market, the price may rise to $7.50. The next big order to sell may bring the price back to $7.45. Trading a more liquid market, for instance a stock index future, which is followed by more speculators, one might expect to see smaller price jumps for the same order, all else being held constant.