Don’t Misjudge Your Liquidity

Don’t Misjudge Your Liquidity

Lack of market liquidity keeps me up at night.

I’ve got scars from underestimating the markets liquidity and the impact my trading size can have on market price. When you increase your trading size, you very quickly learn to appreciate the importance of liquidity in the markets. You learn things like you only get out when the market let’s you and not when you want to. Eventually you will reach a trading size where your positions start to move the market in a meaningful way on a regular basis.

When you want those bids and offers to be there and then the market thins out. There’s no feeling like it.

For those of you out there that don’t understand what liquidity is, it is the amount of buyers and sellers present in the market. In practical terms, liquidity means how quickly you can flatten your position. Low liquidity conditions are where things can really go wrong. If a news event comes out and someone has to dump a large position on to a thin market then that market is going to move and move fast!

I’ve been caught in a decent sized position when the market has thinned out. I had held my trade too long as we drifted towards the Asia trading session. The bids and offers slowly thinned out just when I needed them most. I was left with a dilemma, cut the trade and push the market against myself in the process or hang on to the trade until liquidity comes back into the market. The next liquidity wasn’t going to come around until Europe opened at 7am and I was at the mercy of the markets. There’s nothing like staying up all night only to get your ass handed to you. Really makes you feel good about yourself.

We sometimes forget to tell junior traders how much of an edge they have trading smaller size. Being nimble in the markets is a huge edge. You can get in and out of the market on a whim without moving market price. This just isn’t true if you trade any amount of meaningful size.

A liquidity analysis as a part of the risk process just isn’t something I hear enough of these days. Maybe you trade fixed income and liquidity considerations just aren’t a major factor to you but if you trade really illiquid markets like palladium or exotic forex pairs then you really appreciate liquidity when you get it.

A liquidity analysis should play a major role in your risk process before you place a trade because misjudging your liquidity can have disastrous consequences.

A liquidity assessment is a two part process that involves an assessment of the current liquidity and the prospective liquidity.

The current liquidity assessment is nice and quick and more suited to shorter term trading. You look at the order book and see if there is a normal amount of bids and offers in the book. If you’re familiar with a market and you see a normal amount of bids and offers then this is sufficient. If the order book is thin or if bids and offers start unexpectedly pulling and the book thins out then chances are there is an imminent market moving event. If you weren’t aware of this you should flatten your positions as soon as you can.

The prospective liquidity assessment involves anticipating any time when you think liquidity conditions might change. Liquidity conditions can change at the drop of a hat and when they change, they can change quickly.

There will be times where you know liquidity will change and there will be times where it happens out of nowhere. The best you can do as a trader is to prepare for the times you know the liquidity will change.

I use liquidity considerations and technical analysis for timing.

Stanley Druckenmiller

If Stanley Druckenmiller is taking liquidity into account as part of his trading process then you should too.

It is worth spending the time to think about when there will be illiquid markets, because they represent riskier periods. Just write them down. Your trading plan will almost certainly have to change for these periods. I’ll give a few examples off the top of my head:

  1. Bank Holidays – Less traders trading that day means lower liquidity.
  2. Asia trading – Historically the lowest liquidity trading period. Very few active traders during this period.
  3. Friday Evenings – This is nearly always a low liquidity period. The majority of traders have gone home. The majority won’t want to take trades over the weekend and take on the event based risk.
  4. Economic Figures – Traders will pull orders in case an economic figure comes in outside of expectations.
  5. Central Bank Meetings – Traders will pull orders until they get some certainty about the course of CB policy.

Longer term traders will need to take into account the bigger macro picture and factor in future central bank policy and the impact it will have on liquidity. God forbid we ever get a significant reversal in central bank policy. We’ve already got a taster of the impact of quantitative tightening and raising rates at the end of 2018.

Once you’ve completed a liquidity analysis your position sizing should be a function of market liquidity. You should never be so big that you leave yourself open to unnecessary risk. There’s not a fucking hope I’m putting on size on a trade if I think even for a second that I won’t be able to contain my risk and take the trade off because some of my biggest losers have come from misjudging the liquidity in the market.

Food for thought.

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