Saturday, March 16, 2013

High Liquidity ~ High Efficiency (not good for trading)

Financial products of very high liquidity are often unfavorable by professional traders, mainly due to increased price efficiency. I am going to point out a few ideas on why this may be so from personal experience. I may be wrong, and would welcome any contrasting ideas, as long as we all end up learning something contributing to larger trading profits going forward.

Benefits from high liquidity
High liquidity implies lower transaction costs for exchange participants who engage in purely liquidity-taking executions. This segment of participants includes the following segments:
1)      New traders, often with no positive expected alpha
2)      Buy & hold funds, with no positive expected alpha
3)      Short & hold funds, with no expected alpha in the short term
4)      Pure/Statistical Arbitrageurs, who generate almost purely alpha, and depend on multiple executions simultaneously.

* OTC (Over The Counter) products such as spot FX, CFDs, or CDS do not always offer lower transaction costs despite high liquidity.

So having high liquidity is great, right? Let’s see how that might not be the case.

Liquidity and level of competition
Exchange traded products of high liquidity usually indicates an increased number of smarter, significantly capitalized competition who specialize in liquidity provision and short term alpha. This group of participants is usually institutional in nature, full of very smart analysts and traders working to squeeze every penny out of any inefficiency available.

A more efficient market system is undesirable for less capitalized professional, private traders. Using poker as an analogy, you are expected to make more money playing against newbies than a table full of pros.

Low to mid liquidity conditions, opportunities
From my experience with exchange traded derivatives, a lot of “easier” money making opportunities tend to arise in periods of low liquidity. Here are some examples of opportunities available only in periods, products of relatively low liquidity:

1) Liquidity Provision: Make the market, and get that wider bid/offer spreads from careless, desperate traders who close their eyes, hit the market, and hope for the best. Some exchanges offer a rebate for liquidity provision orders, as a bonus.

2) Pure arbitrage: Different derivative contracts of identical underlying products get out of line against fair values more easily with respect to supply and demand.

3) More “honest” momentum: Easier-to-read tape and orderbook balance for intraday trading success.  

Many other forms of price inefficiency exist in low, mid liquidity exchange traded products, it only takes a bit of digging to find them. Basically, low liquidity ~ more exploitable inefficiencies. It may be counter intuitive, but makes sense right?

0 Reflections: