What is Liquidity in Trading
A security with good liquidity has a lot of active traders, so high volume and high open interest. Liquidity allows you to buy/sell assets quickly without having to adjust pricing too much. A highly liquid security will get you filled very fast with good pricing. This means it has a tight Bid/Ask spread, a lot of volume and a lot of open interest. Even though this is subjective and very relative, I would say that a liquid asset in the stock market is an asset that is traded millions of times every day. Something like the SPY, an ETF that has millions of shares traded every day.
Depending on where you educate yourself, you probably often hear that you only should trade in very liquid assets. In all my options training I always emphasize the importance of only trading in liquid securities. But why is it actually so important to trade in liquid markets? In this article I will breakdown the reasons why liquidity is so important for traders, especially for option trading:
1. The Bid/Ask Spread – Its Impact
The Bid/Ask spread is probably one of the most underestimated and forgotten costs when it comes to trading and liquidity. In fact, many people don’t even really know what the cost of the Bid/Ask spread is despite its consequences. That is why I am here. The bid price is the highest price buyers want to buy for and the ask price is the lowest price sellers want to sell a position for. Typically, the bid and the ask price will be a few points apart from each other. This is considered the Bid/Ask spread. When you buy, you usually can’t get your order filled at the bid price and when you sell, you typically can’t get your order filled at the ask price. This means that you always have to adjust your order price to the upside when buying and to the downside when selling to get filled. This also means that you constantly lose some money when ordering. Let’s say that you open a position in ABC and immediately close it without giving the price time to move. Apart from commissions, this should theoretically end in neither a profit nor a loss. But because of the Bid/Ask spread this will mostly end with a small loss. ABC is trading for 100$, the bid price is 98$ and the ask price is 102$. This would mean that when buying 1 share of ABC, you probably will get filled somewhere around 101$, but when exiting the position, you probably only will get around 99$ for it. This would end in a loss of 2$ without commissions, even though the price of ABC did not move at all. This small loss will almost always be there. Now let’s use ABC for another example. This time you bought 1 share of ABC when it was trading for 100$ and you paid 102$ for it. The stock now rallies up to 110$. The new Ask price is 112 and the new bid is 108. You close the position for a profit and get paid 108$. Even though the stock went up 10 Dollars, you only made 6$ (without the effect of commissions). So you lost 4$ because of the spread. In one or two trades this probably won’t affect you too much. But if you trade a lot, you will definitely lose a lot of money due to the spread. As the last example, we say that per trade you lose 4$ from the Bid&Ask spread. If you now do 100 trades over the course of one year, you lose 400$ from the Bid/Ask spread alone, besides all the other money you lost through bad trades and commissions. As you clearly can see, the Bid/Ask spread can cost you a lot of money. You definitely should be aware of this. In addition to the losses from the Bid/Ask spread, you also lose some money because of commissions. Somehow losses through commissions get so much more attention than losses through the Bid/Ask price.
But what exactly does this have to do with liquidity, you may ask yourself. Well the more liquid a security is, the tighter its Bid/Ask spread will become. A tighter Bid/Ask spread will lead to smaller losses and less money left on the table. Very liquid assets can have extremely narrow Bid/Ask spreads, where you sometimes only lose less than a cent. But very illiquid securities can sometimes have many Dollar wide spreads that can create huge losses in the long-term. I think you slowly get the point.
2. No Market – No Players – No Exits
The next probably more well-known reason why liquidity is important is that less liquidity means fewer players/traders to trade with. A small number of other players can have many consequences and more or less ruin trading. This is because of many things. Fewer players mean fewer people who enter and exit positions every day. This means that filling times will become much longer (learn how to get filled faster, here) because there just aren’t as many people entering and exiting positions at your prices. Therefore, the Bid/Ask spread also becomes wider. You have to understand when your order gets filled, someone else just took the other side of your position. So if you just bought a stock, someone else just sold that one. If millions of people enter and exit positions in securities, it will be easy to find someone who wants to buy/sell exactly the exact opposite of your position at exactly your price. But if there only are a few thousand players, the chances become slimmer and slimmer. Especially for options, because there are so many. For example, stock XYZ is trading for 50$ right now, you buy 1 long call with a strike price of 50 that expires in 3 weeks, the stock loses in value and trades for 30$ in two weeks from now. So your option is at a big loss and only has a few days left before it expires. You think that you will just close the loss before it becomes even bigger. So you try to sell an option with a strike 20$ over the current trading price and expires in a few days. Now think, why should anybody ever buy this option? It could be extremely hard to find any good reason to buy that option. If there are a few million traders in that security, there sure will be someone that is willing to take that option. But if there only are a few thousand traders, you probably won’t be able to sell that option and have to watch how it expires worthless with an even bigger loss. The same goes for winning positions. In illiquid assets, it can be very hard to exit positions. It really can be very depressing to not be able to get out of winning or losing positions when you want to.
3. Bad Pricing
This brings us to the next point, which is pricing. If there only are a few players that want to trade, this means that these players can make the prices. The Bid/Ask spread can become insanely wide. When there only are very few players, the prices can really get out of hand. Just think, if you have someone that really wants to get out of his position, but he only has one other player to trade with. That other player can then solely decide what price he would be willing to take. The trader that wants to get rid of his position has no other choice than to accept this price because there just aren’t any others. This will not only lead to huge losses because of a wide spread and extremely bad pricing, but it will also be very hard to even get an idea of the prices. When millions of people trade and the Bid/Ask spread is fairly tight, you can have a good idea of what a good and what a bad price for a position is. But if the spread is very wide, there only are a few thousand other traders and everybody wants their own price, the desired prices can become very confusing. This may not be too bad for normal stock trading, but if you have some OTM option on an illiquid underlying, the pricing can be very hard to determine, if you don’t have any other prices as a reference.
I hope I made it clear that liquidity really is essential in trading. Anyone who tells you otherwise is probably a scammer or just doesn’t know better. You should always try to trade in highly liquid assets, especially when you want to trade options. It really can be unpleasant when you can’t get out of your winning or losing positions and you lose a lot of money from wide Bid/Ask spreads. I would say that you should only trade assets with (close to or) more than a million shares traded every day. Something like the SPY ETF.
But I want to emphasize the even greater importance of liquidity when trading options. For options, you really need especially liquid assets. Just because an underlying itself has hundreds of thousands or millions of traded shares every day, does not mean that the options are liquid as well. On a good underlying there are hundreds, if not thousands of different available options and for these to be liquid, you really need a lot of people. So if you want to trade options, always check for the liquidity on the option chain itself and not only on the actual underlying’s shares (check the volume and open interest). Even some very well-known securities don’t have very liquid options. I recommend trading big Indexes, big ETFs and very well-known and big stocks to mitigate the disadvantages of illiquidity.
This Article is part of the Intermediate Option Trading Course. If you are reading the article as a part of the course, you can continue to the next lesson: HERE