Futures traders measure liquidity by how easily it is possible to buy and sell a futures contract. The greater the liquidity, the easier it is for buyers and sellers to enter and exit positions. This allows traders to focus on timing their entries and exits rather than wondering if there will be enough volume to trade.
Therefore, liquidity is an important factor when selecting a futures instrument to trade, especially for new traders.
The spread, or the difference between the ask price and the ask price, is largely influenced by liquidity. The more liquid a contract is, the smaller the difference between the bid price and the offer price. With fewer participants, less liquid markets can have a wider spread than highly liquid markets, which typically have a spread of only 1 tick.
To help clarify:
- Ask Price – The highest current price that traders are willing to buy
- Sell Price – The lowest current price at which traders are willing to sell a contract.
- Spread: the price difference between bid and ask
The spread must also be taken into account, in addition to the commission and fees, when calculating the cost of transactions. The most liquid contracts have a “tighter” spread, which makes it less expensive to enter and exit the contract.
How to monitor liquidity?
To track liquidity, traders use the following information:
- Volume: An essential component of liquidity, volume is the number of all contracts bought and sold during a given period. Futures traders will refer to current and historical volume levels when measuring a market’s liquidity.
- Open interest: Also used to measure liquidity, open interest is the total number of contracts for a particular futures instrument that are open at any given time. Used as a barometer of market activity, open interest is the number of contracts held in open positions. David L. Scott writes in his book Wall Street Words , “Large open interest indicates more activity and liquidity for the contract.” Followed by traders around the world, popular instruments such as E-mini and Micro E-mini stock index futures always have high open interest.
- Order book data: Another method used to determine market liquidity is to use order book depth or Level 2 data. Order book depth reveals the number of contracts offered or offered at price levels close to the current price. For example, seeing large bids and offers in the order book would indicate that the market is liquid.
Low liquidity risk
Most futures traders look for liquid markets to trade in, as increased liquidity means traders can enter and exit long and short positions more flexibly.
A primary factor to consider when selecting a contract to trade is slippage, or the difference between a desired or specified price and the price at which the trade actually takes place, and most often goes against the trader. Slippage also tends to occur more frequently in times of low liquidity. Therefore, trading in illiquid markets can potentially increase the risk of slippage.
Traders should choose contracts with the right liquidity for their trading style, position size and risk tolerance, allowing flexibility in their strategy and reducing the risk of slippage.
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