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?

What Does The Average Trader Make? Bad Question.

I'm working through Mike Bellafiore's One Good Trade, so far pretty entertaining/informative, and he made the point that those who come with "What does the average trader make when they begin?" ought to get thrown out of interviews. The results of others have no effect on any individual trader. Like any highly competitive industry, there’s always uncertainty with future performance, regardless of how promising the present appears.

Good Trades are Difficult to Automate
Mentioned in Ramsey Theory and Curve Fitting, patterns can be found in any set of numbers. Therefore a purely quantitative and easily automate-able trading strategy isn’t sufficient for consistently profitable trading. A ton of additional research around economic, corporate conditions, sentiment numbers, and etc. remains necessary.

The resulting trades therefore require human decision making, where discipline, memory, decisiveness, and etc. can be assets, or liabilities.  
 
The Seinfeld Anecdote
George and Jerry are waiting to hear from NBC about how much the network will offer for their pilot for a show called “Jerry”. When NBC eventually offers Jerry and George $13,000 for both of them. 

George yells, “That’s insulting! Ted Danson makes $800,000 an episode.”
Jerry: “Oh, would you stop with the Ted Danson.”
George: “Well, he does… I can’t live knowing that Ted Danson makes that much more than me. Who’s he?”
Jerry: “He’s somebody.”
George: “What about me?”
Jerry: “You’re nobody.”
George: “Why him and not me?”
Jerry: “He’s good. You’re not.”
George: “I’m better than him.”
Jerry: “You’re worse. Much, much worse.”
(Bellafiore, 66)


Reference
 Bellafiore, M. (2010). One Good Trade. Hoboken, New Jersey: John Wiley & Sons, Inc.

Intraday Trading Options Instead of Underlying Products

I have grown to prefer intraday trading options instead of underlying stocks/futures because of the theoretically superior risk management; this allow us to circumvent need for Stop Loss Orders . While the math for options valuations remain somewhat complex, I believe options markets are close enough to “efficient” that a robust edge purely in direction (1 of many Option Greek uncertainties) would be good enough to make money. 

Trading Strategy

Long only ATM (At The Money)/OTM (Out of The Money) options, this gives the trades a limited downside while leaving the trader open for potentially much higher reward. Pretty simple right? Well there’s a bit more to it as risk management still depends on the core logic of the trade. Viability still depends on several risk-related areas. 

Risk Management- Theta

Off actual trading experience, I’ve noticed that theta does not kick in like clockwork as academic theory implies; in the short span within the trading hours option prices are very much dependent on supply/demand within the exchanges, i.e. Market Microstructure. So what does this mean for practical trading?

Trade logic of shorter average position would have a greater advantage. Don’t worry about it in the short run. On some days time value would go in your favor, and some days it wouldn’t. In the long run, the near-efficiency would equal to a pretty small negatively Statistically Expected Value (EV) of roughly the expected Theta * Average Position Time (hours) / 24.

Therefore, the directional edge must overcome Theta + other transaction costs. A theoretical edge that takes your attention is likely to have a much higher EV than the expected damage off Theta.  If not, move on and develop another trade.

Risk Management- Liquidity

If the options are relatively illiquid (such as the ASX200 Index Options), bid/offer spreads tend to be significantly wide, and if the underlying volatility remains relatively low, the inherent transaction cost could sky rocket and make the trade negative EV . Trade the Limit Order Books, blindly putting in Market Orders puts the trader in additional, undesirable risks. 

Risk Management- Time Value

Of course we want to buy the cheapest options possible and work the gamma. We can simply buy the ATM/OTM option(s) at the lowest points off the Volatility Smile.