Liquidity is a fickle companion. Seemingly ubiquitous under most circumstances, it has a way of becoming scarce when most needed.
The recent wild gyrations in markets—including in stocks and options—have caused many traders to reassess their assumptions about liquidity. In the current environment, traders and investors should attempt to be liquidity providers, not consumers, and use strategies common to market makers.
The dictionary definition of liquidity is “the availability of liquid assets to a market or company.” That definition, however, refers to corporate and personal balance sheets and is a poor explanation of market liquidity. In financial markets, liquidity is better understood to be the ease with which an asset can be traded with little effect on its price. Liquid markets show large bid and ask sizes at tight spreads, making it simple for traders to buy and sell their desired securities or derivatives with little price impact.
There is a nasty feature of liquidity that has revealed itself over the past few weeks: It is often inversely proportional to volatility. This is a direct result of how market makers operate. Market makers are traders who commit to post continuous bid and ask prices in their assigned products, and thus are key providers of liquidity. They implicitly agree to be subject to negative selection—in other words, doing the trades that others initiate—in exchange for a better chance at capturing bid/ask spreads.
Every financial transaction needs to balance risk and reward, and market makers must strike that balance countless times a day. Realizing that every one of their posted bids and offers could lead to a trade, market makers use a calculus that optimizes the capital they are willing to commit.
When markets are functioning normally, it is relatively easy for market makers to be confident that their prices are reasonable, and that undesirable or risky positions can be reversed or hedged with little difficulty. By “normal,” we mean that prices move somewhat continuously in modest trends, with relatively balanced trading between bid and ask prices. If the order flow becomes overwhelming in one direction or another, it changes the risk/reward calculus.
What is the market maker’s strategy in such a situation? Many years ago, before this was fully programmed into our models, we had a big sign in our trading room reminding us what to do when markets turned ugly: 1. Widen quotes. 2. Shrink sizes. 3. Raise volatilities.
This is what market makers do in disjointed markets, and what you should do as well. You can accomplish that by trading smaller sizes and demanding more profit for each of your trades. If you normally trade 10 options contracts, trade fewer. Don’t be heroic when prices are moving rapidly in one direction or another. Successful market makers are very disciplined about taking profits and losses and, while every options-market participant should be keenly aware of risk and reward, volatile markets require exceptional vigilance.
Now is the time when you can be the one who is paid to add liquidity by using limit orders inside the posted quote. Rapidly moving markets usually feature wider bid/ask spreads and/or smaller posted sizes. Small investors and traders should avoid hitting bids or lifting offers that cross large posted spreads, along with market orders, which should be avoided entirely, since they consume liquidity. When you set the bid or offer, you are providing liquidity. You benefit from others crossing the spread to trade with you at your chosen price.
And by all means, avoid consuming liquidity by being forced into trades to cover margin calls. It is safer to eschew margin borrowing in volatile markets.
There is an adage that states, “Trade when you can, not when you have to.” Thinking and acting like a market maker can help you meet that goal.
Steve Sosnick is chief strategist at Interactive Brokers and head trader of its Timber Hill subsidiary.
Originally Posted on March 13, 2020 – When Markets Are Wild, Embrace Liquidity
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