Liquidity risk is the risk that a trader or investor cannot quickly buy or sell positions without significantly impacting market prices or facing extended time delays. This risk increases during market stress periods when liquidity providers withdraw, bid-ask spreads widen, and trading volumes decline. Liquidity risk can force traders to accept unfavorable prices or delay transactions.

Managing liquidity risk involves understanding normal market conditions, monitoring market depth, and maintaining appropriate position sizes relative to average trading volumes. Diversification across liquid markets and instruments helps reduce liquidity risk. During crisis periods, even normally liquid markets can experience liquidity shortages that affect trading strategies and risk management.

Real-world example: During the March 2020 market crash, even Treasury bond markets experienced liquidity problems with wider spreads and delayed executions, forcing traders to accept worse prices than normal due to reduced market maker activity.