Derivatives Trading and Liquidity in Financial Markets

I have been intrigued throughout my trading career with the derivatives markets. The recent subprime credit crisis, and the meltdown thereof, have always been a fascination to me. However, my fascination has been somewhat from a distance.

Derivatives and Liquidity

In the early days of trading in the Forex markets, and as an evolutionary process over the years, I have come to a few decisions regarding my own trading. I realized over time that one of the primary ingredients in effective trading is liquidity.

I can quickly look at a chart and determine by the look of it whether a market or financial instrument is liquid. Which of the two ETF charts in this posting would you rather try to trade? One had volume of 2.7 million shares daily, and the other had only 3,400 shares. The difference is not just easy to see; it is also easy to decide which to trade. Trading a very liquid instrument is a critically-important element of effective trading.

For this reason, I have been distantly fascinated to wonder why anyone would create a plethora of innovative, but illiquid trading instruments that no one truly understands, and that few people even trade. Of what value is an instrument that can not be bought, sold, or traded? It can't even be accurately or honestly priced! It may be cool, or it may be hot, but if it isn't liquid, its value and future is questionable.

Brief History of Futures Markets

The futures markets in agricultural products have been in continuous existence since the 1840's. Before that, when farmers brought their products to markets, buyers were forced to pay premium and sometimes astronomical prices during the winter months when grain products were scarce. On the other hand, during the harvest season, farmers couldn't get a fair price, and stories abound of farmers who would dump their wagon-loads of grain on the streets instead of selling them at a loss, because they couldn't get a sufficient price for their products to cover their production costs and feed their families. The futures markets benefit both producers and buyers of products by evening out the extreme and wild price fluctuations that plagued producers and consumers previously. The futures markets level out and provide stability to prices for everyone.

Over time, as more and more market players have entered the markets, liquidity in the futures markets has increased and improved. Speculative players in the futures markets have made them increasingly liquid and stable. This is a benefit to all who buy and sell futures instruments. One recent example of this phenomenon is that when the softs futures became available for electronic trading, prices became more stable and market noise decreased markedly within a few months. Chart patterns have become much more consistent.

Black-Scholes and the Elimination of Risk

On the other hand, when Black and Scholes developed the models and formulas for eliminating risk in derivatives instruments, they didn't find a formula for insuring against the risk of poor liquidity. These models have, over time, proven themselves deficient and thus, incomplete. Many derivatives outside of futures are highly illiquid. In fact, many are so unique and innovative that there is no market for them. Period. In an environment like this, an new type of risk is introduced: liquidity risk. Without liquidity, prices become increasingly unstable and markets become unreliable. This increases the risk rather than eliminates it. It is simply a new form of risk that is impossible to calculate, let alone eliminate.

Liquidity Beneficial for Traders

That is the reason why I refuse to trade any futures instrument that has open interest of less than 100,000 contracts. My mentor taught me only to trade futures contracts that had at least 10,000 contracts of open interest. However, he personally only trades futures that are much more liquid than that. I have come to the same decision on my own.

Liquidity is important to me because it brings price stability to that instrument, and it reduces market noise. (Volatility is beneficial for traders, but market noise isn't. It is our enemy.) Good liquidity, in turn, allows me to improve my trading win/loss ratio by taking trades that have a higher degree of reliability and chart accuracy. As markets become more liquid, charts patterns, and their predictive capability, also become more accurate and reliable. Bid/ask spreads become concomitantly tighter, and the cost to trade is reduced. It becomes easier and earlier to reach break-even and profitability.

That's why I've always been intrigued with the constant creation of innovative and never-before-heard-of derivatives instruments. The more new and creative they are, the less liquid they become, and the more unreliable become those markets. Liquidity risk increases exponentially with the innovative nature of the derivative instrument. I choose reliability over creativity when it comes to placing my money at risk. Only thus can I reduce that risk. Unfortunately, innovativeness is the enemy of liquidity, and thus, profits, in the world of financial derivatives.