How Liquidity Risk Affects Your Trades
When trading or investing, people meet with different kinds of risks. Risk of loss, risk of missed opportunities, liquidity risk, etc. If everyone fears missing the perfect entry point and losing their money, they are not thinking about the liquidity risk. The liquidity risk is barely discussed, although it’s a crucial point of successful trading.
What Is Liquidity and Liquidity Risk?
Liquidity stands for the ability of the company or an individual to convert something they own into cash immediately and at a desirable price. If talking about liquidity in trading, we understand that we don’t own a specific asset. Thus, it is an opportunity to buy or sell an asset fast and without losses.
Liquidity risk is a lack of the ability to buy or sell a security fast and at a desirable price.
Liquidity risk is a situation when there are not enough buyers or sellers in the market who are ready to buy or sell an asset at the price you want. Such an event leads to huge bid-ask spreads and high price fluctuations. The risk occurs because of the marker inefficiency or asset illiquidity.
Liquidity Risk: Types
There are two major types of liquidity risk:
- Market liquidity relates to an event when you can’t buy or sell an asset at the price you want. As a result, you either have to wait for longer or buy/sell your asset at the unsatisfying price.
- Funding liquidity stands for the lack of a company’s ability to pay for its obligations. It happens due to the financial crisis or the company’s ineffective administration, which leads to a funds reduction.
Factors of Liquidity Risk
When you read the news or market analysis, you may hear something like the market suffers from low liquidity. But why are some markets liquid, and others are not? Let’s consider factors that affect the security’s liquidity.
- The number of market traders. It’s the main factor that determines the liquidity in the market. The more traders who are willing to trade the asset you want to buy or sell, the more chances your desired price will be fulfilled.
- Size and frequency of trades. Some of the assets are traded more frequently than others. For example, if we consider the forex market, the EUR/USD pair is more popular than the MXN/USD one.
- Time of trade completion. A liquid asset can be exchanged to cash immediately after the order is placed. However, if a trader hurries to buy or sell an asset, it will raise the liquidity risk. If a trader has time to wait until the desired price is met, the risk drops.
- Substitution. If the position is unique, the risk moves up. However, if it can be replaced with another asset, the risk will decline.
- Type of asset. Assets have a different degree of liquidity. For example, the stock market is more liquid than the real estate market.
How to Measure Liquidity Risk: Liquidity Model
There are several models of liquidity rate measuring:
- The most used is the bid-ask spread, we’ve talked about a lot. If the range is tight, the market will experience high liquidity. It relates to the width.
- Position size stands for the number of assets an investor holds. If we consider a giant company like Microsoft, one investor with several shares won’t crash the market. However, if an institutional investor holds securities in the small market, any of his/her actions can lead to unexpected results. It stands for depth.
- Resiliency relates to a market’s ability to rebound in case of incorrect prices. It counts liquid in time measurement.
The width of the bid-ask spread is the primary measure of liquidity risk.
Does Trading Volume Still Matter?
The volume indicator is a famous measure of market liquidity. Nevertheless, it appeared to be incorrect. It seems logical that high trading volumes signal high market liquidity. However, the real example confirms that it is not necessarily like this.
On May 6, 2010, the flash crash happened when the SEC’s sell algorithms were including orders in the system faster than they were executed. As a result, trading volumes surged while lots of orders were not filled. Thus, volumes don’t mean the market liquidity is high, especially when the volatility increases.
How to Use Liquidity in Trading
Liquidity is a crucial point of trading you should be aware of. Here are several points you should consider.
As we mentioned above, assets have a different degree of liquidity. Thus, to be sure your trade will be fulfilled, choose highly traded securities. Traders prefer those assets that guarantee stability. In the forex market, it’s currencies that relate to the most significant economies. If we consider the stock or bond market, choose blue-chip companies.
Liquidity and Economic Data
The market liquidity depends not only on the asset you trade in general but on market events. Let’s consider the liquidity risk example. You wish to sell them at $15. However, the earnings report was delivered while you were holding the position. This report showed the financial difficulties of the company. As a result, the willingness to buy its shares declined together with their price. So, it’s unlikely you will be able to sell the stocks at $15.
Liquidity Risk and Volatility Risk
It’s essential to understand that these risks are not correlated. In the previous example, we said that a negative earnings report led to an unexpected fall in the stock’s value. However, the liquidity risk would occur if only the asset is not widely traded in general. If we considered a blue-chip company, there would be enough traders to fulfil your position at a desirable price.
Market Liquidity: Which Market to Choose
Let’s consider the degree of liquidity for different financial markets. However, you should know that there is not the most liquid and the least liquid market. All of the markets have more and less liquid assets.
In general, forex is the most liquid market. However, it has both high and low liquid currencies. All major currencies, which are EUR, USD, GBP, JPY, AUD, CHF, CAD, are highly liquid. They relate to stable economies and provide exciting trading opportunities as these currencies are used in global trading operations.
If you want to trade Singapore dollars or Mexican pesos, it’s more likely you will meet a liquidity risk. These currencies are risky assets and are not used in world trading operations a lot.
Thus, to avoid liquidity risks in forex, choose domestic currencies of the biggest economies.
The stock market is one of the most popular places for financial operations. Thus, it’s liquidity is high. However, as you know, there are mammoth leading companies and those that have just entered the market. Traders will invest in the shares of those companies that have been in the market for years and have proved their reliability. Also, blue-chip companies are less affected by market fluctuations and economic releases than those created recently.
The cryptocurrency market is still one of the most volatile. It has always suffered from restrictions of state administrations worldwide. Many new cryptocurrencies were launched, but most of them have disappeared because of low investor interest.
If you want to trade in the cryptocurrency market without a liquidity risk, choose old cryptocurrencies such as Bitcoin, Litecoin, Ethereum, or Dash.
The commodity market is not as liquid as the stock or forex one. There are several assets you can trade with a limited liquid risk. They are gold and oil. Gold is always used as a safe-haven asset that appreciates in times of economic instability. The popularity of gold goes back to the gold standard.
The oil market is famous among traders who prefer to trade on high volatility. Previously, we mentioned that unexpected events lead to a vast difference between the bid and ask prices. However, as the oil market is famous among traders, unpredictable market fluctuations don’t increase the bid-ask spread dramatically.
The Least Liquid Markets
There are markets that are always considered low liquid.
Currencies are divided into major and exotic ones. As we have said, major currencies are the most liquid. The exotic ones suffer the highest liquidity risk. First of all, they relate to unstable economies which decreases the chances for trades. Secondly, many exotic currencies are issued by small countries that don’t participate in global trade relations.
Investors put their money in the shares of giant companies that are more likely to bring high rewards. Small-cap companies are less attractive for investors and traders as the profit is low. As a result, there is a low demand for their shares.
Effective Liquidity Risk Management
It seems that liquidity risk management is easy as you just shouldn’t buy liquid assets. That said, low-liquid securities sometimes provide outstanding opportunities that may increase your profit. Let’s consider several steps that will lower the possibility of liquidity risk.
Securities with low liquidity sometimes provide outstanding opportunities that may increase your profit.
- No long-term investments. If you still want to trade barely usable securities, don’t buy them for an extended period. For example, you want to trade MXN/USD pair because a crucial economic release is supposed to affect the direction of the exotic Mexican peso. Thus, you should choose a small timeframe.
- Think about risks in advance. There is no complete list of assets that are considered to be low liquid and highly liquid. However, there is a primary concept: if an asset relates to a stable economy, market, or company, it’s more likely it will experience high liquidity. If security relates to an unstable economy, young company, or risky markets, it’s more likely it will attract fewer investors. Also, you can evaluate liquidity, by checking the ask-bid spread.
- Monitor. Check the news and economic calendar ahead and during the trading. Unexpected events may cause high volatility that will cost you benefits on low liquid markets.
- Avoid low liquid markets. If you are a newbie, don’t enter low liquid markets as you won’t be able to deal with the stress and losses.
Liquidity risk is an essential point of successful trading. It stands for your ability to buy or sell the security fast, and at the level you desire. The most prominent way to determine the level of risk is to evaluate the spread between the bid and ask price. If it is enormous, the market is low-liquid, and you better avoid trading on it. Usually, exotic currencies and stocks of small young companies provide the highest risk.
Nevertheless, these markets can provide exciting opportunities in times of high volatility. If you would like to test your skills trading low-liquid assets, you should start with a demo account. Libertex offers a fully-equipped demo account with a full range of securities from high to low liquid.
Check the answers to the most frequent questions about liquidity risk.
What Does Liquidity Mean in Trading?
Liquidity stands for the degree of your ability to buy or sell a particular asset fast and at a desirable price.
Why Is Market Liquidity So Important?
The market liquidity determines how fast and successful your trade will execute. If you trade on a high-liquid market, you won’t suffer difficulties, even in times of high volatility. Low-liquid markets may lead to significant losses, even in periods of stable circumstances.
How Is Liquidity Calculated?
The most efficient method to calculate liquidity is to measure the spread between the ask and bid prices. The higher the difference, the lower liquidity is.
What Is Liquidity Risk?
It’s the risk your trade won’t be executed at desired conditions, as there are not enough buyers or sellers in the market who are ready to buy/sell the security. Such an event leads to huge bid-ask spreads and high price fluctuations. The risk occurs because of market inefficiency or asset illiquidity.
Why Is Liquidity Risk Important?
A liquidity risk predetermines the success of your trade. Imagine you want to sell the security at $15, but there are no buyers who would like to purchase it at $15, only those who would buy at $10. You will suffer either a loss of money or time if you wait until someone purchases it at $15.
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