The advantages of liquidity in volatile markets

Updated on

Liquidity measures how quickly a good can be bought and sold at the market price. An instrument’s liquidity depends on its popularity, the ease of transactions with it, and its price. At the same time, liquidity is itself affected by how quickly the good’s stock market price is set and how narrow the range of possible prices is. Besides the liquidity of goods, one can also speak of the liquidity of an entire market. This usually means the number of deals made in a specific amount of time (typically, in a day).

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Q4 2019 hedge fund letters, conferences and more

Determining market prices

High liquidity of a good or a market gives a number of advantages to the participants, especially in volatile markets such as today's. Here are some examples:

Low bid-ask spread and a predictable price. A large number of buyers and sellers leads to a small difference between the lowest selling price and the highest buying price (a fraction of one percent would be a good example). Even if the participant hesitates to buy or sell a good, they can still quickly estimate its market price as they see the offers of other participants.

A way to quickly make a deal at the market price. There are always many participants on the market, even during rapid fluctuations, and each participant can make a deal whenever they deem it the most profitable. For example, if an investor has a stock share that costs $100, but wants to sell it as quickly as possible at a price of at least $90 in the event of a crash, they can request such a deal in advance. With the appropriate level of liquidity of the market, the deal will be carried out as the participant intends.

A way to automate deals. Being able to quickly determine the market price enables the participant to make decisions quickly and frequently. On highly liquid markets such as the stock market, many such decisions can be automated through software, and can be carried out by robots without the trader having to manage everything.

Real Estate Market as an Example of a Low-Liquidity Market

First we shall see how low liquidity can create problems using the real estate market as an example. Even wealthy people rarely buy houses or apartments more than once a year, while most people only do so once in many years. This is due to real estate's expensiveness and fixed geographic location, as well as a lengthy transaction process (which can last up to several weeks).

The real estate market has high turnover, but the low frequency of deals leads to difficulties. A suitable buyer or seller may not come up for months, the market price may remain unknown for long periods of time, and the bid-ask spread for existing offers may be enormous.

If one visits a website listing apartments for sale, the vast majority of the apartments may cost much more than their current market price. They may be listed on the website for months until the seller lowers the price or they find a buyer that wants that exact apartment for personal reasons. Cheaper apartments find their buyer more quickly, and therefore will not be listed on the website for as long. As a result, the prices quoted in the ads are on average noticeably higher than the actual prices that the deals are conducted at (market prices).

When a potential suburban buyer visits a website that offers apartments for sale, they are often unable to find even a single offer at an acceptable price, as the bid-ask spread is enormous due to low liquidity.

Stock Market as an Example of a High-Liquidity Market. Speculators and Market Makers

Unlike houses or apartments, most stock shares are either cheap or can be sold partially. Besides that, owning a stock share does not require one to reside near the company's office. As a result, American stocks from New York's stock exchanges are in high demand far outside the US. The transactions themselves are carried out in seconds due to a high level of automation on the stock exchanges and at the brokering companies.

Typical trading volumes for the stocks of famous companies such as General Motors or Microsoft number in the tens of millions per day, and the transactions number in the millions. At the same time, there can be an enormous disparity in the frequency of the transactions between different traders. Long-term investors may simply gather a profitable stock portfolio, and then wait for the dividends or a price increase for years and not be in any hurry to resell anything. On the other hand, the so-called HFTs (high-frequency traders) can conduct many transactions in a single hour or even a single minute thanks to trading robots.

Obviously, most high-frequency trading strategies are purely speculative. If a rush is happening on the market for no real reason, and the speculator is aware of how unfounded it is, they would still try to make a profit on the rush by pretending to go along with it. In addition to that, the presence of speculators greatly boosts the market's liquidity. They excel at allowing any participant to quickly make a deal. Furthermore, they do not need a large bid-ask spread due to the high frequency of transactions.

Another type of participant that also guarantees high liquidity as well as stable prices is the market maker. Market makers are typically found on major stock exchanges, and are usually companies that are ready to buy and sell anything at the quoted prices. In the absence of a market maker, the market becomes a perpetual auction with constant bargaining between participants, while the market maker turns it into a store where every good has a specific price given in the quote (although it also can change).

Despite the general high liquidity of the stock market, this mainly applies to famous companies. Stocks sold by unpopular companies (especially ones traded at smaller stock exchanges or the over-the-counter market) may have low liquidity and have a turnover of a few shares per day or less.

Differences in Liquidity on Different Markets

The liquidity of a market that trades in cheap assets (or assets that can be sold partially) can be most easily estimated by the turnover of the funds (the trading volume) in a given amount of time.

As an example, the daily trading volumes for the popular stocks of the major companies number in the billions of dollars: $8bn for Amazon, $6bn for Microsoft, $2bn for Visa, etc. The volumes for the top cryptocurrencies are even higher: around $50bn for BTC, and around $30bn for ETH. The next cryptocurrencies on the list are roughly comparable to the top companies by their trading volumes: $7bn for LTC, $5bn for EOS and BCH. These are very high figures.

The national currency market is even more liquid, but there is one important thing to consider here. The main purpose of a currency is not exchanging it for other currencies, but using it as legal tender outside any currency markets. If we only consider the currency exchange market (Forex), it has a lower liquidity, though it is still immense. Forex liquidity must be estimated individually for each currency pair. The highest Forex liquidity in the world is for the euro/US dollar pair (EUR/USD), as this is the most popular currency pair of all.

The total daily trading volume for all currencies on Forex exceeds $6 trillion. About a quarter of it accounts for the EUR/USD pair, which is over $1 trillion, a figure unheard of for other assets that we have listed before. The second place is taken by the pair between the Japanese yen and the US dollar (USD/JPY), and the third place is taken by the pair between the pound sterling and the US dollar (GBP/USD).

Aside from real estate market prices, there are some other markets that also have low liquidity ‒ for instance, the market of expensive art or specialized industrial goods such as large machines or factory equipment. The art market has such low liquidity that the pricing on it depends on random factors. For example, when a famous painting is being auctioned, the result may depend greatly on the participants' mood at the time (primarily, their desire to gamble and hormonal balance). This is why collecting works of art is a rather complicated matter in terms of investment, and it usually requires a serious passion for art. There is always a significant risk that one will be unable to resell a work at a higher price.

Leave a Comment