Key concept to understand: Volatility VS Liquidity. We tackle both of these in this video, and their key differences. You need to understand, as a trader, how volatility and liquidity both effect your trading.
This topic is important to understand because you need to know the details of each market to efficiently trade it.
What is the definition of market liquidity?
Market liquidity defines how easy or how difficult it is to enter a trade. Liquidity is the amount of buyers and sellers surrounding the current price in the market. When a market is re evaluated, say by an earnings report, there will be a sharp drop in the buyers or sellers in that market. You must be careful of low liquidity markets.
Why are low liquidity markets dangerous?
Low liquidity markets can cause problems for you, as a trader. They do not have enough buyers or sellers present for each trade being made. This means that you may have your stop loss level placed, but it will not find an acceptable price as the market may run past it. The stop loss you put in place is dependent on another trader wanting to buy/sell at that level.
When are markets Low Liquidity?
Some markets are always low liquidity because they just do not have enough traders on them. Futures markets like corn or timber do not have the same volume of traders on them as markets like ES 500 or crude oil. Another situation can occur on any market causing low liquidity. This situation happens with earnings reports, industry announcements, and government announcements. When a large change is made in any company or industry, the price of indexes related to that change. This can cause a momentary drop in liquidity until the market balances back out.
Why Volatility VS Liquidity?
These two market principles are closely related therefore we combine them. The relationship between volatility vs liquidity is when there is a volatility spike, liquidity spikes in the opposite direction. For every increase in volatility, there is a decrease in liquidity. To understand this fully, we have to talk about volatility in the market.
What is market Volatility?
Market volatility is the speed or rate of change in the market. It can often be combined with the “fear” associated with that market towards change. When there are a lot of traders who are fearful of price change in the market, there can be quick bouts of buying and selling causing market volatility. Volatility will always be when the market is moving faster in and upwards or downwards direction than usual.
What causes Volatility?
One of the key causes is news announcements, as we have talked about. These are company earning reports, government reports, industry updates, etc. When a company makes a large announcement, the price of that company will fluctuate. This causes the volatility, or fear of change to increase. Every change will result in some sort of volatility. In fact, there is a volatility or “fear index” that people use called the VIX.
How can we relate Volatility VS Liquidity?
Both of these go hand in hand. When there is a volatility spike, there will be a instantaneous drop in liquidity. If there is a low liquidity situation, there will be sharp moves in the market with high volatility. As one increases, the other will decrease. You must pay close attention to what the market is doing in respect to volatility and liquidity as you trade it. A very interesting way to see the relationship between volatility vs liquidity is on tick charts. You can enable tick charts on your platform, and clearly see where and how trades were executed in this video here.
Key strategies to trade Volatility VS Liquidity?
Volatility spikes are dangerous for you. You can avoid the common ones by preparing for known times when the market is awaiting information. These are times when the market is waiting on information, and will react to it quickly. News announcements, earnings reports, government reports, and industry wide changes all will have scheduled announcements. You can easily avoid these turbulent times in the market by having no positions on in the markets that they effect. You prevent yourself from taking unnecessary, and often larger than anticipated losses by avoiding these times in the market. Not only are they high volatility, but they are low liquidity. This is two fold in danger to your trade. Both the lack of liquidity causing stop losses to not be executed, and a market that is running quickly adding to the losses.