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Adjusting Your Trading Expectations In Volatile & Possibly Illiquid Markets

Adjusting Your Trading Expectations In Volatile & Possibly Illiquid Markets

Tyler Yell, CMT, Currency Strategist

Talking Points:

  • Liquidity vs. Volatility
  • The Key Premise Of Trading With Technical Analysis
  • The Enhanced Risk Of Thin Markets And Their Origins
  • Adjusting Your Expectations For Extreme Event Risk
  • How To See The Difference of Volatility and Liquidity
  • Why Volatility Is Increasing In The Age Of Algorithms

“I would argue in today’s environment that liquidity might be one of the biggest risks we face because it might not be as good as we think it is.”

-Mark Yusko of Morgan Creek Capital, May 23

Volatility and liquidity are often lumped together, but they are very different topics that should be understood well. Volatility is a measure of price range over a given time and often utilizes tools like Volatility Bands - which are nothing more than standard deviations around an average price - and average true range readings over a fixed period. Understanding volatility is helpful because the information can help you see where you should place your stops (whether wider or tighter) or if markets have become too erratic for you to trade.

Volatility Is A Simple Number Whereas Liquidity Is a Difficult Concept [Cable Example]

Chart Created by Tyler Yell, CMT

However, liquidity is another animal altogether.

Liquidity is typically seen as the ability to quickly transact in an asset without affecting price or to convert an asset to cash. When there is liquidity, markets operate smoothly. When liquidity decreases or is depleted a liquidity gap can arise.

Liquidity gaps are common precursors to market disruptions and crashes. The easiest way that traders tend to measure risk is through the bid-ask spread; but this shows you what is available now and not the critical information of whether or not you’ll be able to hit the ask or bid when you need to get out of a trade. In addition to the bid-ask, depth of liquidity is a requisite for operational efficiency. When markets are shocked by news - whether it be a Lehman Brother Bankruptcy, Flash Crash of 2010 ( A liquidity crash), or a Chinese Yuan Devaluation - there tend to be pockets of no-bid or no-ask which can lead to a shallow or nonexistent liquidity.

You can think of such events as a Liquidity Black Hole.

The term, ‘liquidity black’ hole was coined by Managing Director and Global Head of Research, State Street Avinash Persaud in 2001. In short, Persuad argues that financial liquidity matters and when liquidity dissipates traders often run to the sidelines that are typically providing stopping points in the markets at traditional forms of support and resistance.

The Key Premise of Trading With Technical Analysis

If you were to spend a few months of your time studying for the first level Chartered Market Technician Exam, you would first be introduced to support and resistance levels. A key component of support and resistance is not the prices in and of themselves, but rather that these levels represent areas for which risk-tolerant investors and traders are likely to enter the market. In other words, a counterparty which is needed for establishing a market.

What many do not consider is that if an event, like an exit of the UK from the Eurozone causes counterparties to avoid trading then the gap risk is extreme because people with exposure begin to panic and offer extreme prices to get out of the market.

Therefore, you can have volatility without liquidity, but you typically will always have illiquidity and volatility together. As we have seen in 2016, volatility is rising.

As economies become more and more interdependent, this trend of volatility and possible pockets of illiquidity are likely here to stay. Certain events such as the CNH devaluation in August and January or a potential shock outcome from the EU referendum on June 23 could exacerbate liquidity black holes and increase volatility in all markets, including the traditionally liquid Forex market.

The Volatility & Liquidity See-Saw

Liquidity and volatility have an inverse relationship. When liquidity falls, volatility rises. Unfortunately, this is the worst kind of volatility (non-tradable) because those wanting to get out of the market find themselves unable to exit as investors are less willing to take the asset off your hands in the current environment.

When volatility and liquidity are balanced, like a flat see-saw, markets are praised for operational and price efficiency. In short, markets seem smart and rational when volatility is contained, and liquidity is abundant. However, at inflection points from event risks catching investors off guard with change and the see-saw tilts as markets seem less efficient where liquidity drops and volatility rises which are denoted as ‘thin markets’. Therefore, the term ‘thin markets’ denotes the liquidity risk that arises due to uncertain liquidity when it is needed.

Adjusting Your Expectations For Extreme Event Risk

When events like the EU Referendum come into view there are typically two views or roads the markets can take that will help determine the amount of volatility and possible liquidity pockets we see.

Data From Bloomberg, Created by Quasar Elizundia, DailyFX Research Team

The chart above shows implied (expected) volatility on GBP/USD over the coming 1 month. The extraordinary levels show the expected volatility by options traders in GBP/USD through the EU Referendum at the end of June. Implied volatility is also known as ‘assumed volatility’ and is the best estimate of how much movement we could see depending on the outcome of the June 23 vote.

Volatility is a double-edged sword that cuts especially deep in illiquid markets. Therefore, in anticipated illiquid markets with volatility assumed to be very high, being on the wrong side of the trade can be one of the most costly mistakes you make in your trading career. Therefore, it is possible that when illiquidity is added to the picture with fewer orders are placed at significant levels, assumed volatility may actually under-represent the risk to traders on the wrong side of a big move.

Why Volatility Is Increasing In the Age Of Algorithms

Orders that represent support and resistance is like the adage, ‘now you see them, now you don’t’. This saying is even more appropriate with algorithms-based trading that sets entry and exit levels with razor-like precision.

Since the Great Financial Crisis of 2008, we have seen liquidity black holes or flash crashes in multiple markets. Over the last six years, we’ve seen the equity flash crash of May 2014, bond flash crash of October 2014, and the index futures flash crash of August 2015 when all three US Equity Indices went limit down before the open.

Takeaway: We’ve broken down the difference between volatility and liquidity; why volatility can change where you place stops; and how aggressive a trend moves. Ultimately, liquidity determines whether or not you can exit when you want to exit.

If an asset cannot be converted to cash or the market cannot absorb a reasonable amount of trading at typical price changes, the market is said to be illiquid. Systemic changes in market view and participation usually bring about such conditions.

When an event like the EU Referendum is on the horizon where there is a high and obviously probability for liquidity to dry-up (order diversity disappears), it is best to either reduce exposure or add margin if you wish to stay in the market through the event risk.

Final Warning: Prepare for the worst, hope for the best. But remember, hope is not a (good) strategy.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.