Does Frequent Trading Always Improve Liquidity?

Abstract

A liquid stock trades more often. The converse of that statement implies that more trading should make a stock more liquid. Extant research does not yet provide unambiguous answer to the critical question: Does more trading make a stock more liquid? We address this important issue using transaction data on a sample of stocks listed on the New York Stock Exchange. We document interesting cross-sectional differences when we categorize stocks on the basis of market capitalization. While more frequent trading is associated with an improvement in liquidity, as proxied by the bid-ask spread, for large market capitalization stocks, the converse is true for small stocks. We probe further and document that the deterioration in liquidity of small stocks, due to more frequent trading, is attributable to a direct increase in the adverse selection component of the bid-ask spread. Our evidence is consistent with the view that when specialists encounter more trading activity for small stocks they perceive increased levels of informational trading.