What is the relationship between liquidity and spread?

• A. Higher liquidity leads to wider spreads.
• B. More liquid products have tighter spreads.
• C. Liquidity does not affect spreads.
• D. Illiquid products have the same spreads as liquid ones.

Answer: (B)

Liquidity and spreads move in opposite directions: when a market is highly liquid, spreads are tight; when liquidity is low, spreads widen. The bid-ask spread reflects the cost of trading and the risk a market maker takes on to facilitate a trade. In a liquid market, there are many buyers and sellers, rapid order matching, and strong competition among market makers. This environment lets trades go through with minimal price distortion, so the difference between the best bid and best ask is small. In contrast, in an illiquid market there are fewer participants and less trading activity, so taking on a new position is riskier and harder to price. Market makers widen the spread to compensate for the greater risk and potential price impact, making it more expensive to trade. So, more liquid products have tighter spreads because trading costs are lower and execution is more efficient.