Liquidity means the ease with which a market can be traded without affecting its price. A market with lots of buyers and sellers at any given time is said to be highly liquid because you'd be able to find a counterparty to buy or sell it easily.
If there are very few people interested in an asset, then it is illiquid. In this case, you might find it tricky to trade.
Major forex pairs are an example of a highly liquid market. The extremely high volume of FX trades each day means that it is highly likely that you'll be able to find a buyer or seller to take the other side of a deal.
Unknown penny stocks, on the other hand, might be illiquid if few traders are interested in buying or selling them.
Why is market liquidity important?
Market liquidity is important because it impacts how prices move and your overall risk on a position.
A liquid market tends to make lots of small price movements as the high number of trades impacts its price at any given moment. An illiquid one, on the other hand, might suddenly leap from one price to another, thanks to a single deal.
Less liquid markets are generally seen as riskier than highly liquid ones.
Say, for instance, that you own a large number of shares in an illiquid stock. Your investment isn't giving the return you want, so you decide to sell the shares.
However, because the market is illiquid, you struggle to find anyone willing to buy the stock. The low demand combined with high supply from your attempted sale could drive the price of your shares down, forcing you to sell them at a loss.
This is known as liquidity risk. Liquidity risk is less of a factor when trading with a provider like FOREX.com, as we will always take the other side on any market we offer.