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How to Avoid a Liquidity Trap

How to Avoid a Liquidity Trap

Talking Points:

- Liquidity is extremely low in many key asset classes, and this can present a troubling scenario for the month ahead. Traders need to exercise extreme caution going into the end of the year as the potential for massive price swings exists with numerous geo-political issues combined with an already illiquid environment.

- A rising rate cycle in the United States is likely dampening participation in many key asset classes across many different markets, and Christopher Vecchio outlined the historical significance that a ‘lift-off’ might bring into key asset classes like Treasuries. Lift-off, whenever it may be, could produce a watershed moment across financial markets.

- We touched on the danger of liquidity in current market conditions in the article, The Top Three Risks Facing Global Markets Right Now, and David Rodriguez elaborated on the topic in his article, Three Factors Warn of a Perfect Storm in FX Markets – Caution Advised.

- There are three ways that traders can address a ‘personal liquidity trap,’ and we outline each below. For those that are willing to take the risk of trading in a volatile and illiquid December, proactive order types like ‘Market Range,’ or ‘Range Entry’ can help to control slippage or gaps on entry or exit orders (picture below, full article follows, this topic is addressed in more detail towards the end).

Market range orders on Trading Station II; prepared by James Stanley

In Keynesian economics, a ‘liquidity trap’ is a very, very bad thing. This is when injections of capital into the banking system by a Central Bank fail to decrease interest rates, and in-turn, make monetary policy feckless. This is like the death knell for Central Bankers, because this means that regardless of what they do, an economy is set to recess and there isn’t much that they can do about it. In many cases, their continued action at this point merely makes the situation worse (similar to the Great Depression).

But since this isn’t a concern, at least for right now as neo-Keynesian economics is being employed at full-blast around-the-world, we’re going to borrow this term in order to re-apply it to an area that’s probably a lot more relevant for independent traders right now.

Another type of a liquidity trap is you getting caught in a position that you can’t get out of without taking a monstrous hit to your investment. Think being long real estate in 2007 before the real estate house of cards came tumbling down. Or, like being long Japanese Stocks in 1989 before the Nikkei broke (and I use that term lightly, as the index tumbled over 82% in the next 20 years).

Deconstructing Liquidity

The basic definition of Liquidity is the ability to get out of an investment without having to take a hit to price. So, something like a 17th century Victorian brooch is not going to be a very liquid investment. If push comes to shove and you have to hawk this at a pawn shop, you’re probably not going to get fair market value. A Rolex, on the other hand, is considerably more liquid because there is a strong base of built-in global demand for the product (and the name brand). So, if you have to sell this to a pawn shop, you’re probably going to take less of a hit, on a percentage basis, than a more-niche item like a brooch. The Rolex is far more liquid than the brooch because more people would want that product, and hence, there is a lower chance of the pawn shop getting stuck with this as inventory that can’t be moved.

Liquidity is an incredibly difficult thing to quantify because it’s going to be a function of a number of other factors that are all dynamic and real-time in nature. Sure, we can look at bid/ask spreads, or we can read an order book to see how much depth is behind the bid and ask of an individual market at a given time; but as shocks come into a market these numbers can change dramatically. And any of these metrics for grading liquidity are merely looking at historical information that, like price analysis, isn’t going to perfectly predict future conditions.

The big danger is what happens if liquidity dries up in a market in which you’re trading. This can mean horrible fills on entries, combined with punches to price on your way out. In this case, you have no choice but to take the hit if you want to get out after getting slipped or gapped on your entry, or you run the risk of watching your position swung around like a rag-doll as illiquid conditions can bounce prices to and fro.

Of pertinence to traders, liquidity helps balance volatility in a market. Think of liquidity like a buffer. A very liquid market will have considerably more (and larger) buffers than a less liquid market, as there are sitting stop and limit orders above and below current price action that can absorb buying or selling pressure should an event create a price movement in a market. The below illustration draws up the most simplistic explanation of this premise possible:

To be sure, liquidity can turn on a dime, just like price action, and this can have a massive impact on your investments. Liquidity in real estate seemed very robust going into 2007. And then Bear Sterns got hit by their over-leveraged portfolio of real-estate holdings, and as the ills of an overly-exuberant real estate market were coming to light, all of the sudden liquidity vanished. If you happened to be invested in real estate, or CMO’s or even REIT’s, you got caught in a liquidity trap because that once high-flying investment now looked down-right anemic, and nobody wanted to buy that junk off of you at the previous fair market value. Banks got risk-averse, and there was very little reason to hawk on the bid to buy assets that were seeing precipitous selling around-the-world. So, as liquidity on the bid of real estate investments dried up, selling pressure took over and created violent down-side movements that, putting this lightly, were quite uncomfortable.

So, rather than classifying such a key component of the market, liquidity, by using historical figures and back of the envelope math, we can probably more aptly address the topic of liquidity by addressing another key component of market dynamics: participation.

In a market with more participants that are more willing to act, there is a higher probability of traders coming into buy or sell (more orders + more activity = more liquidity). But in a market with a lower probability of traders coming in, well now we have the fear of a liquidity trap, as even the slightest of stimuli can create a significantly adverse price movement that can be difficult for the trader to get out. Think of being back in the crash of 2007, and while your real estate investments are tumbling in value, all that you have left are 17th century Victorian brooches to offset the margin call that you have on the other side of the portfolio.

The Worry for Right Now, and Going into The End of Year

Most of those historical methods we have for grading liquidity all look abysmal. And while this doesn’t necessarily predict that liquidity will stay low, it does signal something that could continue to drive illiquid environments: Fear. The reasons for participation are at lows, as we are looking at the potential for significant volatility in the last month of the year from the US and the Federal Reserve, Europe and the ECB and the situation that is continuing to develop in China.

With so many geo-political and economic factors in the air, combined with the numerous pressure points that banks around-the-world have faced over the past six years, liquidity is drying up (or has dried up) very quickly. And it’s not just in FX markets, this is happening in many different types of stock and bond markets, including treasuries, which are often considered to be one of the most liquid investments on the planet. Liquidity is drying up in stocks as these movements higher are not being accompanied by strong volume; and as the Federal Reserve looks at that first interest rate hike in over nine years, most major market players are likely reticent of being overly-exposed should a major shift take place.

This is the classic conundrum of trying to pick up a penny in front of a moving train. Sure, the penny is sitting there, lonely, just waiting to be picked up. But there is a train coming at full-speed (this is like the upcoming rising rate environment), and this should rightfully bring on a second thought about jumping down on those tracks to pick up that penny. That’s what many banks are looking at right now. And nobody wants to get hit by a full-speed train when the up-side was a mere penny, especially the smartest risk takers in the world.

For you, the individual trader, there are really only three things that you can do.

1.Avoid it altogether. Cash is a position too, and markets aren’t made for heroes. Many banks and liquidity providers are choosing to sit out until the end of the year to see how this whole situation shakes out, so this is a very relevant idea and could be a very smart way of going about it. The best part about markets is that they’ll likely be here tomorrow (unless, of course, the Neo-Keynesians get hit with a ‘big picture’ liquidity trap).

So, if you’re looking to play a ‘big short’ theme, you’ll likely have ample opportunity to enter on the way down after the down-trend has been confirmed.

2. Use Proactive Order Types, Like Market Range or Range Entry Orders: This is one proactive way that traders can control liquidity crunches. On FXCM platforms, a market order can be entered ‘at best’ or as ‘market range.’ Market range merely means an acceptable range of prices that you’d be willing to take on. So, if you clicked on a price of 130.51 on EUR/JPY and set a market range of ‘2.0,’ then you’re saying that you want to be entered as long as the trade could be matched at a range of 130.49-130.53 (a range of 2 pips above and below the price that you had clicked on).

Proactive orders can be used on entry orders as well with the command ‘range entry’ next to the desired order type.

That way, if prices had moved significantly from the time you tried to enter the order to the time it hit FXCM servers, the order will be canceled as an acceptable price could not be had.

To learn more about market range orders, please click here to be redirected to FXCM’s website to view a full video on this order type.

3. If you insist on trading through these volatile, illiquid conditions, accept the risk of what you’re doing and realize that the results may not be pretty: This is a harsh truth of markets. Market prices aren’t determined by GDP or earnings or CPI or Central Banks or any of that stuff. Prices are determined by supply and demand, and that is determined by sentiment that will likely be determined by a combination of all of that other stuff.

But without confidence, and without wide-scale participation, the manifestation of that supply and demand becomes extremely murky. Even good data has a tendency to get shrugged off in a down-trending market; in much the same way that bad news gets shrugged off when the largest Central Banks in the world are adding liquidity at a breakneck pace. That’s what leads to things like the 2007 real estate bubble blowing up, or the 2000 tech bubble bursting.

There is a reason why liquidity is so low right now: Because we’re at a potentially major turning point in markets. After six years of ZIRP and as the Federal Reserve looks at that first rate hike in nine years, we’re beginning to see breaks in peripheral economies around the world. Emerging markets haven’t recovered from the late summer swoon across risk assets, and commodity prices are continuing to peel lower, which will likely spell even more pain for commodity-based economies moving forward. Nobody really knows how this whole situation is going to play out because neo-Keynesian economics, at least in its current form, has never faced such troublesome tests.

--- Written by James Stanley, Analyst for

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