Most explanations on this topic about adding and removing liquidity simply state that market orders remove liquidity and limit orders add liquidity. Is it possible to have a bit more elaborate explanation as to why this is so?

Marketable orders REMOVE liquidity.
Non-Marketable orders ADD liquidity.

I guess before understanding the above, I need to understand what exactly is liquidity as applied to stock markets? Does it simply mean stocks which are trading frequently and there is a huge number of buyers and sellers?

  • Tip: the proper way to quote in markdown on SE is to select the text then use the icon that looks like double quote, or prefix each line with a greater-than symbol, ">". The four space prefix is for quoting source code or other text that must be quoted verbatim with fixed-width font. – Chris W. Rea Feb 1 '14 at 22:03
  • This would be a great question for the new area51 proposal, a Q&A dedicated to trading! area51.stackexchange.com/proposals/50387/trading – grayQuant Feb 1 '14 at 22:38

Not all limit orders add liquidity, but all market orders remove liquidity presuming there is liquidity to remove.

A liquidity providing order is one that is posted to the limit book.

If an order, even a limit order, is filled before being posted to the limit book, it removes liquidity.

Liquidity is measured by a balance and abundance of quantities posted on the limit book and the best spread between the lowest ask and the highest bid.

  • 2
    Thanks. If liquidity is measured by the quantities posted on the limit book, is that a fair measure of the liquidity? A stock may have many 'buy' orders posted on the limit book but no sell orders. In this case, is the market considered liquid? – Victor123 Feb 3 '14 at 15:53

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