Futures traders measure liquidity in terms of how easy it is to buy and sell a futures contract. The higher the liquidity, the easier it is for buyers and sellers to get in and out of positions. This allows traders to focus on timing their entries & exits rather than wondering if there will be sufficient volume to trade.
As a result, liquidity is an important factor when selecting a futures instrument to trade, especially for new traders.
The spread, or the difference between the ask and bid price, is largely influenced by liquidity. The more liquid a contract, the smaller the difference between the bid price and the ask price. With fewer participants, less liquid markets might have a wider spread than highly liquid markets which usually have a spread of only 1 tick.
To help clarify:
- Bid Price – the highest current price traders are willing to buy a contract for
- Ask Price – the lowest current price traders are willing to sell a contract for
- Spread – the difference in price between the bid and the ask
The spread should also be considered, in addition to commission and fees, when calculating the cost of trading. More liquid contracts have a “tighter” spread making it less expensive to enter and exit the contract.
How Do I Track Liquidity?
To track liquidity, traders utilize the following information:
- Volume: A critical component of liquidity, volume is a tally of all contracts bought and sold within a given period of time. Futures traders will reference current and historical volume levels when measuring the liquidity of a market.
- Open Interest: Also used to gauge liquidity, open interest is the total number of contracts for a particular futures instrument which are outstanding at a given time. Used as a barometer of market activity, open interest is the number of contracts held in open positions. David L. Scott writes in his book Wall Street Words, “A large open interest indicates more activity and liquidity for the contract.” Followed by traders the world over, popular instruments such as E-mini and Micro E-mini stock index futures have consistently high open interest.
- Order Book Data: Another method used to determine market liquidity is using order book depth, or Level 2 data. Order book depth reveals how many contracts are being bid for or offered at price levels surrounding the current price. For example, seeing large size bids and offers in the order book would indicate that a market is liquid.
Risk Associated with Low Liquidity
Most futures traders seek liquid markets to trade, since higher liquidity means traders can more flexibly enter and exit long and short positions.
A main factor to consider when selecting a contract to trade is slippage, or the difference between a desired or specified price and the price where the trade is actually transacted and most often works against the trader. Slippage also tends to occur more often in times of low liquidity. Thus, trading illiquid markets can potentially increase the chance of slippage.
Traders should choose contracts with appropriate liquidity for their trading style, position size and risk tolerance, allowing flexibility in their strategy while reducing the chances of slippage.
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