Talking Points:
- Liquidity is a dominate force in the financial markets, and its rise or fall can shift trends or revive an inactive environment
- Thin markets usually lead to small market movements as has been the case with the S&P 500, but it can also leverage as with Oil
- A known period of thinned price action can also motivate speculative repositioning as with the Dollar, Aussie and Bitcoin
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Liquidity rules everything around me. It has also been one of the most consistent references I have made in my trading videos over the past few months. In the level of participation and the breakdown of the participants, we can derive motivation and influence which is the closest you will ever come to precognition in the markets. In typical analysis, we usually see liquidity grouped in as a subcategory of technical or fundamental analysis which means it is usually used to explain past events to justify technical patterns or to establish whether a market will respond to an indicator or not. That doesn't just do a key measure of analysis a disservice, it misses an over-arching filter that can significantly improve our understanding of the market we operate in.
In appreciating liquidity first and foremost, we understand the landscape of our present circumstances. Most traders do this inherently, without fully appreciating the influence of what they are evaluating and how it can better prepare us for different periods and conditions. This being the final week of the year between the Christmas holiday and New Year's, the running assumption is that the number of active traders will dramatically decline. That in turn leads to substantial changes in the market's activity profile. Typically, in these markets, we expect activity to look much like what we have found in the S&P 500 and other major equity indexes around the world. In this popular trading asset, we have seen a severe drop in volume and general price range. When there are far fewer traders in a market, that tends to occur. However, thin liquidity can also lead to significantly different results depending on the circumstances.
When there is a shallow pool of traders, a sudden urge or need to bid or unwind an asset can lead to sharp movement in price. That is what we witnessed in US oil this past session. News of a Libyan pipeline explosion that would impact the small OPEC member's output led to a far more violent rally than we would have expected during 'normal' trading conditions. This intensity fits the thinned market, but a trend should be looked upon with serious skepticism. In the anticipation of a liquidity drain, we also find that speculative exposure often rebalances. That often means that traders that have ridden a common view/trade for a while will book profit before the tailwind dies down. That is what we saw on COT figures for large speculative interst in the Dollar and Australian Dollar. And, sometimes, there are even unique situations where liquidity doesn't impact all players equally. That is the case for Bitcoin and other cryptocurrencies. Without an exchange to be off for the holiday while traders are still spurred by self preservation or appetite for yield, this can draw even more interest. We focus on the impact that liquidity can have on markets with prime examples in today's Quick Take Video.
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