If you want to trade, two things are essential. First, you need a trade idea. Second, you need a market in which you can execute that trade.
Dylan and Tom kicked off today’s discussion with Tom sharing his opinion as to why liquidity is so important. The simple fact of the matter is, a trade idea or opportunity is only as good as the market’s liquidity. Liquidity is a measure of how close to a “fair value” you can execute a trade at. A lot of market participants (high volume and open interest) and narrow or “tight” bid/ask spreads where the difference may be only .01 or .02 indicate high liquidity. It means that your “slippage”, or the amount away from the trade’s fair value, is low.
Market liquidity facilitates our ability to enter and, perhaps more importantly, exit a trade at our choosing. Most traders have experienced a winning trade become a losing trade simply because a lack of liquidity kept them from being able to close the position.
In the second half of today’s episode, Dylan was joined today by Beef, Jared, Katie, and Nick, dropping the average age in the room by nearly 25%. It was an opportunity to discuss with other tastytraders not only their take on liquidity, but what might cause someone to deviate from caring about liquidity.
We all have opinions and egos. We want to trade those opinions and we are not all immune from doing so. Take “Once in a Decade” Jared for example. He acknowledged placing a trade earlier this morning in an illiquid product. Yet at the same time, he was the same person to point out that liquidity is what allows for a fair market. Without liquidity, a single large order could potentially take down an entire stock.
If Jared understands why liquidity is so important, why does he ever trade in something illiquid? Dylan summed it up best. As traders, we face a battle between being seduced by our trade ideas and the fundamental rule of whether we can get into and out of a position. It is not always easy, and the bigger your ego, the more difficult that battle might be. But there are some ways to make sure you stay in liquid products.
Katie has moved on from equities to futures. She trades a lot in futures options and brought up a point that some find frustrating. When Katie sees bid-ask spreads widen in normally liquid futures options markets, it means a potential red flag for her.
Liquidity is vital for many reasons; trade entry and exit top the list. Another might be, when we see normally tight markets in very liquid stocks such as SPY widen, it can be a tell. Tom has spoken about it before. When markets have crashed in the past, bid-ask spreads in out-of-the-money puts suddenly become very wide. Therefore, to Katie’s point, we can use liquidity as a potential indicator.
Dylan, Beef, Jared, Katie, Nick and Tom all agree about the need for liquidity and so should all tastytraders. Its importance, as Dylan said, is self-evident. Liquidity is the gate between ideas and whether we should execute on them. You can jump in a pool if you want. Just check to make sure there is water in it first.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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