Why Is Liquidity King In Trading?
Have you ever wondered why gaps in price occur or spreads widen? Are you aware of the risks of trading in instruments where the liquidity is low? In this article, we are going to go on a deep dive into this topic to ensure Global Prime clients are well informed of the role that liquidity plays in trading.
Disseminating the term liquidity
Regardless of how long you’ve been trading, at some point you should have questioned the depth of the market you are trading. In other words, its liquidity. Make no mistake, trading an asset like the EUR/USD offers far different conditions than trading an instrument like CAD/NZD for instance.
It is true that, in its simplest form, trading comes down to an instrument appreciating or depreciating in value. You’ll still have to press the buy/sell buttons to enter your orders, work out your targets and invalidation points (stop losses), etc. However, under what conditions you do so matters. It is crucially important for traders with skin in the game to note that such conditions will, by and large, be highly influenced by liquidity!
Liquidity is the indisputable #1 element to make a market functionable and competitive. In brinkmanship terms, liquidity refers to the ability to buy or sell an asset easily and at a stable advertised price. For a market to be rich in liquidity, there must be an ample participation of both buyers and sellers, in other words, a big audience of willing takers and makers.
This leads us to then ask the following question…
Why is the pair EUR/USD so popular? Plain and simple, because it concentrates the trading activity of the two currencies most in-demand globally. The USD as the world’s reserve currency has no rivalry, followed at a fair distance by the large trading activity taking place in the single currency.
It is therefore no surprise that the EUR/USD draws the most interest and participation. This makes the pairing of the EUR vs the USD a market extremely high in liquidity. On the flip side, one could think of an asset like the CAD/NZD, where the amount of daily total transactions, given the thinner trade ties between the two countries and the size of the latter, represents a pale proportion in activity compared to the EUR/USD dealings.
The role of liquidity providers
Liquidity is directly correlated to the quality of your trading experience. Traders should constantly seek out the best possible conditions as it relates to slippage, gaps, spreads, fast execution and ideally volatility.
At Global Prime, the richer the liquidity of a market, the easier it becomes to cater our clients with what they are after. The more liquid a market becomes, the more willing participation exists by liquidity providers (LPs), also known as ‘market makers’. It is the largest Tier 1 banks are providing liquidity to the range of products available at Global Prime as market makers.
The primary liquidity providers in the over the counter Interbank market, primarily concentrated in Forex, include market makers operating at major banks. They are generally willing to quote both a buy and sell price on an instrument to both their professional counterparties and to non-professional client counterparties.
Market makers are generally compensated by the differential between the bid rate and the ask rate in what is typically known as the dealing spread. The dealing spread is charged for providing this liquidity as a service.
These LP divisions within banks, due to their constant dealings with corporations that require foreign exchange transactions, are in a privileged position to exert the role of principal liquidity providers. They generally quote a two-sided price based on how they anticipate currency movements will take place and what they think the counterparty might be interested in doing.
A high concentration of LPs creates a highly competitive environment in pricing the instrument. This leads to narrower spreads (the difference between the bid and ask prices). Why? Because the more LPs that interact with each other, the more they can reduce the costs of making forex trading transactions for clients (case in point FX majors). This facilitates trading in general since pricing tends to be tighter and more readily available.
Conversely, how this is differentiated from more illiquid instruments such as the CAD/NZD is by the lesser number of participants trading, hence less LP’s pricing these assets, which results in wider spreads.
Liquidity transcends beyond spreads
It’s not only spreads clients should care about. A market with poor liquidity is at higher risk of filling clients orders with slippage (different trade execution price than intended). This risk is dependable to the size traded and liquidity available at every interval. What this means is that if you are a large player looking to fill in a sizable buy/sell order in a thinly traded pair like CAD/NZD, you may be exposed to a worse average price (slippage). Why? Because your order may not find enough counter-parties at the advertised price.
The comforting part for retail traders looking to get filled in the odd 1 or even 10 lots? Any instrument offered at Global Prime should be able to absorb this type of order size without any slippage issue even if one will still have to incur the marginal increased spread between the bid and ask prices.
A picture paints a thousand words
In the exhibit below we find a graphic example of why poor liquidity can be a problem. This is a DOM (depth of market) from the futures market (it’s the same in any instrument = buyers and sellers competing).
Imagine placing a market order for 1 contract at 17.525. Because there are no sellers at that level, the order will be filled at 17.775. This is the spread between buyers and sellers — the double whammy may be that when it comes to sell, the same issue may occur again but in reverse.
This is what we call an illiquid market.
That’s why liquidity has a direct influence on both the spread and the slippage. It could easily wipe out all of your profits. On the flip side, one can see the difference in the DOM below where there is almost no spread between buyers and sellers. Orders will pretty much be filled at the level specified.
Volatility at the whim of liquidity
The peculiarities of a poorly liquid instrument don’t end just with spreads or risk of slippage. We also must consider the degree of volatility. Volatility is not necessarily a bad thing, in fact, it is what breeds opportunity. Typically, the more liquid an asset is, the more stability tends to offer in its daily moves.
In fact, if you are a short-term trader, you may find this video on the relationship between the spreads and the volatility quite interesting. I call it the cost efficiency ratio. The logic is pretty simple. If you are going to be paying up on the spread side, you want to be compensated by larger volatility. The worst combination is a market with both a high spread and lower volatility. You generally want more projected vols if higher spreads.
While there are other variables such as the extent of demand/supply imbalances that will also determine the average daily range or volatility, all else equal, a market that enjoys far more ample liquidity is likely to sustain and anchor its price movement within a more confined range given the constant buy/sell audience that exists.
The richer the liquidity in a market, the more market makers (LPs) stand generally ready to add in layers of bids and offers in order to stabilize prices. This same practice can be more costly for LPs looking to engage in illiquid markets depending on the order flow hitting the books. LPs need to care about the liquidity in a market because it is very hard to manage risk if you’re on the wrong side of a big move in an illiquid market.
The anatomy of opening gaps
As a result of trading illiquid markets, a familiar risk arises. The daily opening gap. Why does it typically occur at Global Prime? To go full circle in understanding what causes, one must be reminded that Global Prime is one of the very few brokers that gives direct access to the market through an A-book (orders go straight to LPs). While our business model comes with great benefits, there is one minor aspect to bear in mind.
There is typically a period of 30-60m from the New York close until the opening of financial centers in Asia where very few LPs will be quoting. Since this may become an issue for clients with open positions and a relatively tight stop loss, at Global Prime, we do have in place mitigation risk mechanisms.
During market opens, when the liquidity providers pricing into Global Prime switch online (Monday session start) and switch offline (Friday session end) the spreads can be wider as the liquidity providers reset and liquidity is low. To ensure our clients positions are not stopped out by the widened spread, we commence pricing on Monday 2 minutes after the market open and close pricing on Friday 3 minutes before market close.
The same thing during the daily trading break. There is a daily 2 minute break in trading from 23:59–00:01 platform time. Clients are able to see the prices streaming during this break. No orders can be placed and pre-existing orders cannot be executed during this time. This is to safeguard from positions with a Stop Loss getting hit by the potential spread spike that can occur over rollover when Liquidity Providers reset their pricing for the new trading day at 00:00 platform time (which is 5pm New York ET).
Liquidity microstructures: switching pools on & off
Let’s now briefly dive into another critical aspect. Did you know that a market can be highly liquid yet still face episodes of poor activity in its books. This is quite predictable in the lead up to major risk events, which results in the inevitable expansion of gaps, slippage and poor order execution.
Why does this phenomenon occur? Let’s dive right into it.
The most significant of this type of news includes changes in monetary policy by central banks, updates on inflation data, GDP numbers, employment figures or politically-driven events. Another form of news events, scheduled over the weekend, may also create gap risks the following Monday.
News-led gaps are caused by the interbank market pulling its bids and offers within minutes or immediately before/after the news hit. Once the news release is known, interbank traders slowly re-establish their prices based on the news catalyst. It is the brief low liquidity period that can cause quite a stir in the price (in terms of both gaps and slippage).
As a trader, you must be aware of the risk you are facing if you are holding a position ahead of a news event. You will often be subject to gap risk and be taken out of your position if your stop loss is too tight.
Which products are most liquid & illiquid?
If we think of the Forex market, we can use the data collected by the Bank of International Settlements. In its Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets, we can clearly observe that the USD, EUR, JPY and GBP drive the most volume. It is therefore no coincidence that the combination of these currencies tend to be the most popular to trade amongst clients at Global Prime.
Source: https://www.bis.org/
As per individual stocks or stock indices, the main determinant to understand the levels of liquidity has to do with the time they are traded. Even more so than in Forex. Since a stock or its index is closely linked to the global performance of equities in a particular country, the instrument will be far more liquid during the morning business hours of the market’s time zone.
As an example, the S&P/ASX 200 index, which represents a market-capitalization weighted index of stocks listed on the Australian Securities Exchange, will see plenty of transactions (liquidity) going through the books in the early hours since the opening bell. Conversely, during the evening time, while the ASX200 index will still be open to be traded through Global Prime, the liquidity available will be comparatively negligible.
In the commodities front, these are products that attract predominantly fundamentally-oriented players for all types of reasons. From speculation to hedging. The top instruments include gold, crude oil, corn, gas, soybeans, and wheat. All these products are available to be traded via Global Prime.
Main take-away: Liquidity matters a lot
It is fair to conclude that illiquid markets do pose inherent risks that should not be taken for granted. If liquidity ensures market participants’ ability to buy and sell easily, by the same token, an illiquid product carries possible unforeseen disadvantages that have been detailed through this article.
We should not ignore liquidity as it directly correlates to the conditions in which a particular asset will be priced, under what dynamics and how much it is expected to be moved on average. As a consequence, this inevitably will influence our trade management given that the size of our stop loss or profit taking targets will also have to be adjusted in accordance. You cannot treat in the same manner, trade management wise, a EUR/USD 1-hour trade with a highly active participation by a zillion participants than the EUR/Turkish Lira.
This leads us to ask the following question: Does this mean that poor liquidity us effectively a canceler to trade a particular market? No, it is not.
It all depends on the strategy deployed or trade management style one feels most comfortable. For instance, if you are a mean reverting trader looking to fade overextended movements in a particular asset, volatility is your ally. If that is a prerequisite for your strategy to be active, you’d want to seek out volatile markets, which tend to be linked with poorer liquidity.
That’s just one of the endless reasons why, at Global Prime, we open the doors to trade anyone from (almost) any background (if we don’t it is because we are forced not to by regulators) a wide range of assets. That’s why we aim to cater the broadest possible spectrum of styles and strategies for you to thrive. We will keep doing so, but never at the expenses of not first doing our utmost to properly educate clients on the market mechanics at play.
