Liquidity risk is the risk that a given stock cannot be traded quickly or efficiently enough in the market to prevent a loss (or make a required profit). In other words, it's the possibility that you won't be able to buy or sell a stock for a reasonable price within a relatively short period of time.
A lack of liquidity is most commonly evidenced by a wide spread or price difference between the bid/offer. A wide spread is typically caused by purchase and sale price inefficiencies due to low average trading volume in a particular stock. The bid-offer spread is used by market participants as an asset liquidity measure. This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that stock within a relatively small price range between the bid and ask price. As a result, liquidity risk directly affects your ability to trade. Lack of liquidity may also contribute to slippage which is the difference between your estimated transaction costs and the amount actually paid.
Be aware that a manifestation of liquidity risk is very different from a drop of price to zero-also known as principal risk. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if you cannot find another party interested in trading the asset, this can potentially be only a problem of you and potential market participants finding each other. This is why liquidity risk is usually experienced in emerging markets or low-volume markets.
Liquidity risk tends to compound other risks. If you have a position in an illiquid asset, your limited ability to liquidate that position at short notice will compound your market risk. So, if you can't sell a stock due to a lack of liquidity in the market - it becomes a sub-set of market risk.
The best way to avoid liquidity risk is to only invest in stocks that have an average daily volume of at least 500,000 shares or more. Higher volume for a stock is an indicator of better liquidity. Sufficient volume typically ensures that there is enough daily activity between buyers and sellers to keep the spread between the bid/offer relatively narrow. A narrow spread means greater efficiency, less slippage, and fewer surprises about the price you expect to get when you buy or sell stock.