Sunday, June 28, 2009

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Should You Trade in Liquid Stocks or Illiquid Stocks?

Should you trade in liquid or illiquid stocks?Image Source

Liquidity is an important property of a stock. It is in fact not just for stocks but for any asset that can be traded with money. Many people trade stocks without ever knowing about this property of their stocks. For a professional stock trader, who trades with strong trading principles, liquidity becomes one of the major properties to consider in his/her trading. Continue reading to learn more about its importance as well as what is liquidity if you did not know.

What is Liquidity?

Liquidity is a popular term in finance but I did not know it until last year. Even though I heard about it and its importance in the first ever seminar I heard when Anand Agarwal (from Hyderabad) presented about investing and risk, I did not quite understand it at that time. As I started trading on my own, and learning new lessons at one point of time I could quite understand the right meaning of this in relation to my own trading.

Liquidity of an asset is defined as the ability to sell or buy it quickly in the market without affecting its price. You must have heard that a stock will rise when it is bought and will rise when it is sold. In reality if you think again you will note that there is a seller for every buyer and a buyer for every seller. Then how come you can say that the stock is only bought or sold?

The fact is not whether the stock is just bought or sold that determines its movement. It is the change in value of the stock in the mind of buyer or seller willing to transact the stock at any time. At any point of time there will be orders for sell above current market price and orders for buy below it. If buyers want to buy the stock at any rate immediately, what should they do? They should just rise their order price, then immediately it will match against the sellers’ prices and gets executed.

How Does Liquidity Play Role in the Stock Market Movements?

When too many buyers behave in the same way then the stock starts showing a definite movement in the upward direction. This is the reason why the stock moves with buy or sell actions not just by their simple meaning but due to as described above.

That means stock moves when you make a transaction aggressively by changing your order to get executed quickly. This is only when you do not find enough number of stocks with the matching opposite orders. But what if you find? Then the stock price does not move in the up direction if you buying. In other words the stock appears stable.

Now to make sure that the stock makes some move at all times, we need to have liquidity. That is there should be buyers and sellers constantly trying to match their orders. No matter who trades them and how many trade these stocks, the point is to have very little impact of your trade on the price of the stock. Even if you sell your stocks in huge volume, it should regain its earlier price in a very short time (in seconds).

So Liquid Stocks Regain Their Shape

That is how liquidity works. You must have noted the relative stability of the big companies and especially the large caps mentioned in the stock exchange indices like Sensex for BSE or Nifty for NSE. This is because of their high liquidity. Liquidity, if you take literally ,also tells that the asset is more like a liquid in which you can quickly put your hand, pull something out and it still retains its shape after a little time. If it is like a solid, then whatever small piece you add or take from it creates a mark or change in its shape that remains like that for the rest of the time. Illiquid stocks behave like that. If you traded them, you can see the impact of your trade for a long time to be noticed by the Securities Exchange Commission.

Hence liquidity is referred to as the ability to trade an asset without altering its price. In reality different stocks have different amounts of liquidity. For that reason their daily movement ranges and the volume of transactions too differ.

Those stocks are highly liquid which are traded heavily with huge number of transactions per second compared to any other stock. With these stocks you can get in quickly for the price that you see as the CMP (current market price) at that time. You can also get out of the stock quickly for the price you see as CMP. In less liquid stocks it is not possible to do so easily. In other words liquidity determines how many shares you can transact at any given time in a given stock.

Liquidity Gives a Safety Edge for a Trader

Liquidity thus gives you flexibility to play the game easily. So it is safer to invest or trade those stocks that are highly liquid or traded heavily than otherwise because you can get in and out of them pretty fast. Examples of these stocks are many in Nasdaq as 100s of millions of shares get traded on them. For ex, Apple, Nasdaq Index QQQQQQ, QualComm, Texas Instruments, Cisco, Microsoft, etc. On the National Stock Exchange in India, the stocks in Nifty like ICICI Bank, HDFC Bank, Reliance, RNRL, etc are highly liquid. In general, NSE is more liquid than BSE.

Now you must have already understood how liquidity can be used. If you are a stock trader (or share trader), then you should go for highly liquid stocks. Especially if you are going for short term trading or intra day trading. When you do short term trading, you should be able to get in at the price you want to get in and also trade with the same number of shares that you would have done with long term trading. The reason is that regardless of short term or long term trading, a stock can give the same amount of return. You got to do long term compulsorily when liquidity is less.

Hence short term traders bet relatively large money in a short period of time. To absorb their impact and not to affect the stock price movements we need to select those stocks whose daily traded volume is very high. At the end of the day somebody has to absorb your moves right :). For example, for day traders or short term traders, many stocks on Nasdaq and RNRL, Reliance, JPAssociates, DLF, Adlabsfilm, etc. on NSE are right type of stocks.

But it does not necessarily be vise versa for the long term traders. I had explained the difference between long term trading and short term trading and when to use them in an earlier article. The long term traders often target stocks that may not necessarily have good liquidity. For example in the year 2007, the top 20 stocks that gave highest returns as much as 2000% in a year are the stocks that have low liquidity. It happens like all of the time.

Illiquid Stocks Too Are Important, But Play Carefully

This does not mean that you can not trade them. Many people get turned off for low volume and ignore them thinking there may be some scam involved. That is wrong. There is a professional way of trading these stocks. And institutional investors always employ such tactics to get in and get out of any stocks easily and quickly without draining out the stock or skyrocketing it. In fact institutional investors trade with a big deal of money that they mostly settle with highly liquid stocks like Infosys and Reliance. Just check the fund allocation into stocks of any mutual fund and you will find this.

With low liquid stocks, you should never consider short term trading. You should only do long term but with a proper strategy in deciding the number of shares to trade. You can also buy the stock not in one trade, but in several at different times in different order for the same or closely similar prices. It takes time for these trades to get executed as there may not be much activity on that stock.

Similarly while getting out as well, it can become extremely dangerous with illiquid stocks. You may want to get out at certain price but as you start reducing the exposure you will see that the next lowest buy order is at a huge gap. Either you need to have enough patience to wait till it gets executed (it often does) or lose money in the process. As the margins of profit for short term trades are less than that for long term trades in illiquid trades, it is never a good idea to trade illiquid stocks for the short term.

In many cases the right time to decide to sell is when the trend of the stock reverses and by then the illiquid stock too becomes very liquid due to the hype and attention it had accumulated over time. And if you do not get out then, it will become illiquid again as the stock falls. Then you can never get out with a reasonable profit from it.

Liquidity Changes with Market Trends

Note that not all stocks can be just separated as liquid and illiquid stocks. Each stock has a certain level of liquidity. Hence you should understand this level of liquidity of a stock from its daily volume of transactions. Often this becomes highest during bull markets or at the peak price of a stock.

Once you know about liquidity, now you should consider it while creating the list of stocks to trade for short term and long term separately. Sometimes you should add some stocks or remove some from the list as the liquidity of stocks can vary depending on the type of investors that trade it from time to time.

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