BACK TO BASICS: Understanding the Importance of Market Liquidity
June 26, 2006
Liquidity is a very important factor to understand in the trading world because it represents the ease with which financial instruments can be traded. Liquidity basically boils down to the volume of trading activity that enables a trader to buy or sell a security or derivative and receive a fair value for it. A high volume of participants trading a market is required to make it rewarding. Liquidity provides the opportunity to move in and out of positions without difficulty.
Typically that is why at-the-money options have better liquidity because they have a better probability of being profitable than out-of-the-money options. Since they are easier to trade many traders concentrate solely on the at-the-money contracts. That is why when you visit a major exchange you can easily spot what pit has the most opportunity.
If one pit has just a few people hanging out basically not doing much and in the next pit has hundreds of people fighting for an order, it is quite easy to spot which market has the most liquidity.
The bottom line is that plenty of players equates to opportunity. It is important as a retail trader to be able to avoid illiquid markets. One way to do just that is to determine whether trading volume is high or low, increasing or decreasing. Though it is not totally black and white on just what is enough volume a good rule of thumb is at least 300,000 shares every trading day.
Given that there are no absolutes, there are situations where this 300,000 shares per day rule can certainly be thrown out the window in exchange for common sense. The most important thing to keep in mind as a trader is that an abundance of buyers and sellers as well as a heightened volume of trading activity generates high liquidity.
This high liquidity gives traders the ability to move in and out of a market with relative ease. High liquidity provides tight bid ask spreads which reduces slippage costs unlike illiquid markets which can make the trading process much more difficult as well as much more costly.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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