What is market liquidity? Why is it an important consideration when trading the markets?
The definition of a Liquid market is a market in which selling and buying can be accomplished with minimal effect in price.
Let’s look at a real world representation of market liquidity and see what conclusion you come to. The screen shots shown below in two boxes are commonly referred to as a DOM (Depth of Market) or Trade Ladder. Both markets are futures, but the idea is the same for other markets.
- The center column shows the price of the market.
- The left of this center column is bid size and this measures how many bids are at each particular price.
- The column to the right of the center column is the ask size and this measures how many asks are at each particular price.
Please compare the number of bids (buy orders) and asks (sell orders) in each box.
- Which market has more bid and asks?
- Which market has a smaller differential between the bid and ask Price?
- If you were going to enter an order to buy (go long) 25 contracts, which market do you feel would be more able to absorb that order when using the definition for a liquid market mentioned above?
The box on the left represents the market that best characterizes the correct answers to these questions. The market shown in the left box has a quantity of 219 bids and 474 asks at the current market (see orange underline). In contrast the market shown on the right box has 3 bids and 1 ask with not many bid and asks supporting those (see orange underline). Now look at each center column (Price) which will display the minimum price size or tick, the market on the left is 1 tick difference whereas the market on the right has an 8 tick difference.
Here are a few additional questions to consider:
- As an investor, trader, speculator, etc. does it make sense to participate in a market where the ability to enter and exit leaves as little impact on the market as possible?
- Which of the markets pictured above would generally be subject to larger price swings a liquid or non-liquid market?
The real world of trading has costs that are associated with them. You have trading costs like commissions, exchange fees, etc. You must factor in the spread of the market price when determining your break even. It should be rather obvious then that a liquid market will allow you the chance at entering and exiting the market with minimum impact on market pricing. A non-liquid market (picture box on right) certainly shows that any significant volume needing to be traded would be met with some larger price swings and wider price spreads.
The type of trading you plan on doing is also a very important consideration. If you are going to buy and hold a position over a long period of time then deep liquidity is not very important. A day trader does need deep liquidity and needs that liquidity during the times they are planning on trading.
ETN (Exchange Traded Notes),
ETF (Exchange Traded Fund),
Stock Index Futures Options (aka Equity Index Futures Options),
Stock Index Futures (aka Equity Index Futures),
High Frequency Trading,
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