A reader, Mohammad, asks:
I see you mentioning liquidity or a market being too thin to trade. I'm not sure what this means or how to measure liquidity. Please help.
Ok, this is one of those basic questions that deserves good attention. First of all, the term "liquidity" is used and misused in so many contexts that it's easy to get confused (And probably not your fault, since you'll see the same word meaning different things!)
In this case, when I speak of liquidity, I basically mean we can get in and out of a market without too much slippage or market impact. We also want to give some consideration to what will happen when you trade with more size. For instance, in stocks, you can pretty much get in and out of any stock (within reason) with 100 shares, but even 1,000 shares might be different… and 10,000 shares or more might be very different.
What we're looking for is a market with:
- A reasonably tight spread
- Enough size in the book to cushion orders beyond the first level or so in the book
Now, a few caveats. First, this is a dynamic measure. Even a very liquid stock may be surprisingly thin at some times of the day (e.g., midday at lunch.) A major currency pair can have a really wide spread in the off-hours, etc. So you probably do need to assess liquidity at the time you place a trade, even if it's as simple as thinking "I'm trading during liquid hours, so I'm probably ok".
To decide if something is liquid enough to trade, I'd use different measures for different instruments:
- Stocks: Average volume
- Futures: Average volume and open interest
- Options on the above: More complicated because sometimes apparently thin options are surprisingly liquid. Thinner options will require more execution skill (i.e., working midpoint orders, working exchange-supported spreads where available, etc… basically just not banging the bid and offer).
- Currencies: Major pairs and crosses are liquid during trading hours for those countries. Minors and "exotics" can be very illiquid, and some of them exceedingly illiquid. At the very least, check the spread when you are about to execute. Your broker may provide stats such as average spread by time of day, etc.
Why didn't I give threshold numbers? Because it's really impossible to give standards - half a million shares in stocks, a few tens of thousands of contracts of a futures market - that's probably a very rough line for beginning traders, but you want to watch markets and understand what you're comfortable trading. Too many beginning traders trade things that are too thin (One of the reasons is that many of the scammers focus on these thin names because they can manipulate them with their chatrooms… when the stock pops, you're filling the chatroom owners' orders all the way up the ladder. Don't believe this happens? Ever wonder why you can't make profits like the guy in the ad with the rented car claims to? Hmmm…).
I've just scratched the surface here, but this is a topic that all traders need to be aware of, and developing traders probably need to pay more attention to. Everything else in trading is so difficult… why make it harder than it has to be by getting slipped a bunch in a thin market?
Last thought: There's a flip side to this coin. Illiquidity can work in your favor, as well. In fact, one way to define a trend is as a failure of liquidity on one side of the book. There are few feelings like being on the right side of a trend when people are trapped on the other side in a thin market, but beware - if you're going to grab the tiger's tail, you better have the skills to deal with that tiger!