Greetings traders and welcome back to another Survival Guide.
Chris here, bringing you some more information.
Today, we're going to be covering market liquidity.
Market liquidity is one of the core concepts of trading.
It's important to understand how it works,
so that's exactly what we'll be covering;
how it works, what it is, and why it's just so important to understand how to read.
All of that and more is coming up. But before we go any further, would
you do me a favor and click that like and subscribe button down below, so I can
keep coming out with these videos for you guys.
Without further ado, let's get going.
Liquidity is among the most important concepts in the financial
and investments world.
It is essential for the well-being of the exchanges, the trading venues
institutional investors, retail traders, that's us,
and basically everyone with access to the financial markets.
We're going to cover exactly what it is when a market
is liquid. We'll start there. Market liquidity indicates the
ease of converting assets into cash
without affecting their price, and that is an important concept.
It's the ease of converting them into cash without changing
the price of the underlying asset to a great degree.
Well, why cash you might be wondering. Well, because cash
itself is the most liquid asset.
It allows you to exchange it for basically everything.
If we think about what cash is, that helps us better understand
what the definition of it is to be liquid as an asset.
Cash can become anything. It is a liquid asset. We can think of
liquidity as a trade-off between the asset's price and how
quickly we can buy or sell it.
The quicker we can trade the asset without affecting its price, the more
liquid it is. Liquid assets guarantee that there will always be
a market participant who will be on the other side of
your trade and allow it to happen.
In general, the more liquid the asset,
the more stable its price is. Liquidity is considered a reflection
of the market's health. Investors always prefer liquid markets,
as they equate to more stability and less risk for their
long-term strategies. On the other hand,
the lack of liquidity is a state of the market or asset where
we are struggling to convert that security into cash and
it's usually not a happy scenario.
This means there are not enough buyers at all, or at least
not enough buyers to agree to our preferred terms.
This so-called "illiquidity" causes assets to prevent us from capitalizing on
a particular trading opportunity that we might be hunting
because we can't buy or sell at the exact time and price
that we so choose. By being stuck in an open trade and failing to find buyers,
usually the trader will start to become more willing to accept
a worse and worse price, just so they can close the trade off.
This is why we say that the lack of liquidity is
such a burden to traders that are trading the markets.
Market liquidity depends on the number of buyers and sellers and
the transactions between them. The more buyers and sellers
on the market, the more stable and transparent
the prices are. Market liquidity is dependent on the investment
public's interest in a particular asset.
For example, if we were to talk about say Apple, it is much
more liquid than shares of an average tech company and that
is due to the fact that Apple itself is a well-known business
with solid fundamentals and an extremely strong investor desire
over the company, which creates multiple buyers and sellers
on a daily basis. According to theory, in a liquid market the
buying price, the bid price, should be close to the selling price,
which is the ask price. Usually the difference
between them is just a few pennies, or much less than 1% of the price.
This indicates that the buyers and sellers views are rather
similar and transparent in a stable market economy. On the other
hand, when the spread between the bid and ask price widens,
the market is considered to be less liquid at this time.
The difference in the spread may be up to a few percentages
of the trading price in less liquid assets.
Illiquid markets make it harder for investors to buy and sell at their
preferred price. How liquid an asset is depends on several things.
One is the asset class. For example, equities are much more
liquid than real estate. The liquidity of other assets like
derivatives and commodities, often depends on their size and
how many open exchanges they are traded on.
Generally speaking, instruments traded on big exchanges
enjoy the highest liquidity. On the other hand, instruments
traded on dark or less developed markets tend to be more illiquid.
The New York Stock Exchange is multiple times more
liquid than other markets, such as the Afghanistan Stock Exchange as a simple
example. Market liquidity also depends on the time of the
day that we are trading. Trading after hours almost always
means fewer buyers and sellers on the markets, which means less liquidity.
Trading foreign instruments like the Euro during Asian trading hours will also result
in lower liquidity. If we wait and trade the instrument
during the official hours of the European Exchanges,
we will surely find a better bid-ask spread.
To imagine what liquidity looks like in numbers, if we were to imagine
the example of Google's trading volume being at say, 1.3 million
as it was in the early stages of October of this year,
this sounds like a lot, but if we were to put it in perspective,
the trading volume for Tesla shares on the same day were 42 million.
Once again, Google is 1.3, Tesla 42 million.
Both stocks are considered highly liquid and we can trade
them without any real worry of getting stuck into the trade
without a counter party to get us out.
But we want to make sure that the liquidity of the market
we're trading is there before we begin trading it.
Are market liquidity and volatility related?
Well, high market liquidity usually leads to low market volatility.
On the other hand, low liquidity can destabilize prices.
Markets with sufficient trading volume are known to have stable prices
and a good environment in general for the institutional traders.
Assets that lack enough investment interest are usually
a ground for speculation. This means their prices are unstable, which
is why they are considered riskier and unhealthier markets.
An example of highly liquid and less volatile assets are
bonds and blue chip stocks. To better understand the relationship
between market liquidity and volatility, think of orders as
a way for companies or individuals to vote on where the market
is going next. As we know, the more votes collected, the more
representative and trustworthy the final result will become.
Now let's translate that concept in the context of trading. In that case, the bigger
the number of buy sell orders there are,
there's high liquidity, the more stable the price
will get, which means low volatility.
This means that volatility and liquidity have a reverse relationship.
If volatility increases in most cases,
this is an indication of lower liquidity. On the other hand,
if liquidity jumps, then volatility will most likely decrease.
Here, we should also mention the fact that the relationship
between liquidity and price does exist. An asset is truly
liquid when buying or selling, even large quantities and
at once it doesn't significantly affect its price when you're doing this.
Imagine a situation where we live in a small
neighborhood and managed to sell our house for a significantly
higher price than the average on the market.
Then our neighbor does the same. Due to the small number of
real estate available, or the small number of houses available
in this region, the chance of these two events happening will
drive the average housing price higher because your house sold higher.
This is relatively the same concept with stocks.
If an investor holds a significant portion of the shares
of a company with low trading volume and dumps them all at once,
he will drive the shares of the price down.
These investors are usually called "whales" because they can
cause price splashes, as it's referred to, in an illiquid market.
Because most market participants' primary goal usually
is capital preservation, liquidity often becomes the make it or
break it point that defines whether to enter a particular market.
If investors want to ensure more stable and less risky performance,
they will look for markets with high liquidity.
Historically speaking, market liquidity has often served as a warning sign
of looming problems with the economy. One of the reasons is that
the lack of liquidity may often contribute to the formation of market bubbles.
Let's take the housing bubble for example. During the last two decades,
we have witnessed several housing bubbles across the world,
one of which led to the most devastating financial crisis
since the great depression. A housing bubble forms when the
number of sellers on the market surpasses the number of buyers
with a great margin. The market then becomes illiquid, without
it being reflected in the price, if the price is now moving
disproportionately, I mean. When there is an equilibrium between
buyers and sellers, the demand is stable which leads to more houses being built.
This on the other hand leads to higher real estate prices.
At some point, buyers start investing in real estate not just
to live in, but to profit from it. This further increases the demand.
However, this process is finite and once it reaches
the critical point where the supply significantly surpasses
the demand, the market becomes a illiquid and the prices get volatile.
The real-estate loses value and at some point the bubble bursts. Of course, there
are several other factors that also contribute to housing
bubbles like cheap credit for example, but you get the idea.
The case with markets is quite similar. Stable and liquid
markets are a sign of a good and healthy environment.
They allow institutional investors like pension funds and
insurance companies to take part and invest their capital.
If we were to think of liquid assets, we have to remember
that a liquid asset is going to be one of those assets that
allow us to quickly convert it into cash without affecting
its price. We can think of liquid assets as the most popular assets.
If we try to think of some examples perhaps we'll
think of things like say, Apple, or Tesla, or Netflix, or futures
on commodities like oil, gold, or corn, US treasury bonds, currencies,
etc. The list goes on and on.
These are all examples of strongly liquid assets.
This means that we have an asset that we can invest in
usually without worry that we're going to have a gigantic
spread or an inability to close out of our position.
The general consensus is that an asset is liquid when it
can be bought or sold in a few hours.
Now, most of us are more interested in buying or selling in
a few minutes when we're actually trying to get out and all
of the assets listed are examples of assets that should be no issue.
It's worth noting that an asset that is highly
liquid today, may not always be enjoying such an interest a year or a decade later.
Apple today could be highly liquid, but 10 years from now
it's entirely possible that it may be illiquid at that time.
The concept here is to understand that liquidity is never
a guarantee forever for any particular market just like
any aspect of any kind of business.
No business is guaranteed to be successful forever.
However, the most successful businesses will usually experience
high liquidity during their lifetime.
The pros and cons of liquidity are relatively summed up to
the fact that more liquidity is usually better but we'll
talk about the risks because they are technically associated.
The risks really just lie in the periods of low market liquidity,
because low liquidity leads to those unstable prices like
we talked about and worsen market conditions.
This is why investors with significant exposure to a particularly
low liquid asset are considered a potential source of high systematic risk.
They are considered to be an investor that exposes
themselves to this unnecessarily high systematic risk, because
if the instrument's price starts going south and the investor
decides to dump his assets, then it can lead to a snowball
effect and it can tumble even further and in the end smaller
investors will end up losing the most. Low liquidity should
serve as a warning sign that if we decide to invest in the
particular market, the risk of getting stuck in it, in an unstable
market period is quite high, and we may not be able to execute our orders,
so this is quite dangerous. It's worth noting that during
periods after dramatic political, global, or market events,
including the post 9/11 period in the US, the months after
the global financial crisis, all of these periods.
These are areas where the market became illiquid as fear
and uncertainty took over and more investors head for the
exit and there's less opportunity for people to get out of
the market where they want with a counter party. On the benefit
side of liquidity, liquidity is the fuel that powers the financial markets.
The good thing is that most of the time when
the economy is doing well, the global situation is stable
and there is relative equilibrium between the buyers and
sellers in multiple markets even in those niche specific assets.
As an investor, we can realize that even during
periods of low liquidity or dramatic events,
the markets can still be a healthy place to trade.
The Covid pandemic recently is a good example of that. The financial
theory behind how the different sectors were hit would point
to the fact that the tourism sector arguably was hit the
hardest because of the travel restrictions, but that's
mostly right. Now, it isn't universally correct
however, because areas like booking.com, for example, a business
that should be stagnating in these times, has actually been
doing quite well and they've actually managed to expand their
business further for future bookings down the road.
What this comes to show is that no matter whether
it is low or high liquidity in the overall market,
it is still entirely possible that there can be other liquid
markets occurring even when it doesn't seem so on the surface.
To wrap it all up, liquidity is something that most traders
strive to look for in the markets and with good reason.
It allows us to do so many things so much easier.
But until next time folks, please make sure you click that like and
subscribe button down below and I will see you soon.
Happy trading everybody. Happy hunting. Over and out.