Asset Liquidity Vital To Stock, Options Trading
How easily can you get out of your next trade? How much liquidity is there in the underlying asset or options contract?
These are important questions for every trader in an uncertain market that can shift sharply with the wrong news headline.
Multiple events are ahead next week that could negatively affect low liquidity trading setups.
Avoiding trade setups with low liquidity
A recent online advertisement featured a kayaker paddling slowly through the smooth water of a large idyllic river surrounded by beautiful scenery.
Before long the kayaker had a sudden realization that the current was carrying him steadily toward a giant waterfall with only one way out – a massive fall to the churning bottom below. The kayaker saw what was coming and had no way out.
Traders who work hard to find an ideal trade setup with just the right price with all the right signals may find themselves in a similar situation. Unlike the kayaker about to fall to a watery crash, these traders realize – often too late – that they have worked themselves into a trade setup with low liquidity.
Low liquidity means fewer buyers or sellers placing trades in the selected market. This creates added risk to the trade because, as the cost of buying or selling increases, traders may not be able to exit the trades to take gains or avoid losses. There simply aren’t enough traders on the opposite side of the move.
Falling into this low liquidity trap can happen when traders are jumping at a “great price” on an asset without considering trading volume and liquidity factors. This can be a common scenario on lesser known assets, often cheaper in price, that market participants aren’t buying or selling in higher numbers.
Traders need to understand more than just price action – a great price and no liquidity could be a waterfall scenario.
Market pressures can negatively impact liquidity
The impact of low liquidity affecting a trade setup can be harsh for traders, creating a feeling of no escape.
Low liquidity can be compounded due to various unexpected pressures on the market or the specific asset under contract.
Pressures such as overnight trading; global economic events; a stock market event; a Federal Reserve or Federal Open Market Committee announcement; earnings reports, or unexpected company news can play havoc on a trade setup.
Keep in mind key events scheduled for next week.
These include data releases for the U.S. Consumer Price Index (CPI) on Tuesday and U.S. Producer Price Index (PPI) on Wednesday.
CPI measures consumer costs for high-value staples such as housing, gasoline, utilities, and food. PPI tracks wholesale cost changes – the price of goods sold by manufacturers.
There is more to come the following week when the Federal Open Market Committee (FOMC) meeting takes place Sept. 21-22. The FOMC plans to raise benchmark interest rates by 75 basis points.
Any of these events could spur a market reaction.
A sudden market move – rally higher or gap down – that goes for or against the trade position can restrict exit options for a low liquidity trade. There just aren’t enough buyers or sellers.
Traders can be forced to watch as all their plans for a trade come crashing down.
Navigating bad September history
Volatility in the stock market fueled by uncertain economic data – 40-year high inflation, rising interest rates, consumer price increases, jobs instability – can create fear among market participants.
The more fear the less interest in exposing capital for more risky trades, such as a low liquidity options contract on a lesser-known asset. Volatility, like this on-again, off-again bearish market, can restrict cash flow in the markets, further enhancing low liquidity setups.
Historically, September is considered a low liquidity month for the stock market. There is no end to theories about why this happens each gateway month into the fall. But the statistics over the last 75 years bear out this month as one of weakest for stocks on record.
Supply, demand fuel asset liquidity
An essential concern for any trade is whether the underlying stock or option can be bought or sold quickly without affecting price.
Traders should keep in mind the long-established principle of supply and demand. No matter how good the price of a stock or option, if there is little demand (volume) for that contract there will likely be low liquidity. Sometimes a stock with a great price is attached to a company that attracts little interest from market participants.
Without liquidity in a trade, the setup may create an insurmountable negative outcome.