One of my fascinations with trading is that you can buy or sell a product in mere seconds. How nice would it be if we could buy and sell a house or a car in that short a time frame? It's a compelling thought, and it makes me wonder if real estate investors would benefit from such a technological luxury.
Ironically, it was the risk averse side of my personality which attracted me to trading. That may seem counter-intuitive, but consider that an investor might label themselves as risk averse if on principle, they buy an undervalued asset with the intention to sell it at a premium shortly thereafter because they can expect the asset to appreciate in value with high certainty. Aside from the argument that asset values fluctuate and can depreciate beyond expected levels (as with
the housing bubble of the last several years), they are likely ignoring a key risk factor - liquidity.
Simply put,
liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Being that markets are unpredictable, they are susceptible to changes in interest rates, bubbles, and other economic indicators which may decimate the value of assets on a macro level. When such unforeseen changes occur, the last thing you want is to be burdened with an asset you can't offload, which underscores the importance of liquidity.
Traders may erroneously believe themselves to be exempt from illiquid markets, but some fall victim to a false sense of security. An example I routinely share when illustrating this is the infamous so-called, "penny stock," which is any stock trading under five dollars. Retail investors are routinely drawn to penny stocks by the lure of low share prices. All things being equal, conventional logic dictates that there would be an advantage to buying a share of stock for a few dollars as opposed to $450 (any Apple
AAPL fans out there?), where $4,500 could buy you 1,500 shares of a penny stock as opposed to 10 shares of Apple. This way, when the shares appreciate in value by a point you can increase your leverage exponentially dollar per dollar to make a considerably higher profit.
The issue with this line of thinking is that relatively few investors dabble in penny stocks as compared to the blue chips, giving penny stocks a far cry from the liquidity of the companies trading on the S&P. Pull up a chart from any penny stock and if you're used to watching price action on the
e-Mini S&Ps or ETFs,
QQQ, and
SPY, you'll think your computer monitor has frozen.
Why is this important? Because you don't want to find yourself in the predicament of having bought a security at $3.46 near the top of a range on a rally, have it reverse its trend against your position, and although the last price the security traded at was $3.42, the low liquidity determines that you will only find buyers at the $3.37 price level, a full five ticks below the last price traded augmenting your loss. Had you been trading a security with more liquidity, you likely would have been able to sell the stock at $3.42 or $3.41, thereby reducing your loss and risk.
As for futures contracts trading on the CME, I recommend you review the volume and open interest reports found on
their website prior to selecting products to trade. Today, I am trading Canadian Dollar futures which had an
average daily volume of over 70,000 contracts in January 2013. Forex futures trading on the CME have a high volume of transactions leading to high liquidity and are an ideal market for traders.
The largest and most liquid market in the world is said to be the interbank foreign exchange (forex) market, which is estimated to have a
daily turnover of nearly $4 trillion. Within the forex market, liquidity varies between the major and minor currency crosses, with
EUR/USD having the most volume and liquidity. I personally have not traded currencies in the interbank market because of my preference for currency futures.
Regardless of which asset class you trade, there are several factors traders consider and liquidity should be on the top of the list. Aside from whether you like the security's fundamentals or technicals, research and check daily volumes to ensure that you can reduce your risk by trading a market with high liquidity.
Disclosure: I have no positions in any stocks mentioned, and
no plans to initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business
relationship with any company whose stock is mentioned in this article.
