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when the market opens (increasing the slippage a day trader experiences). A trader can get a good understanding of the overnight risk by researching the frequency of gap openings and amount of that difference. Really large gap opens occur infrequently, and very rarely are more than 5 to 10 percent of the price of the underlying contract. |
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2. Liquidity risk. The market sometimes becomes illiquid enough so that you get filled at prices that adversely affect your equity. Often whenever the liquidity of a normally liquid market becomes thin, it means that the market could be at a turning point. Whenever a normally liquid market experiences low liquidity, the price is generally moving quickly in one direction, resulting in price slippage. Typically liquidity risk increases whenever there is crucial news or a government report is released. Whenever liquidity dries up there is a price vacuum, resulting from an imbalance of orders due to the news event or a lot of stop orders at certain price levels. |
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The more the liquidity of the market dries up, the worse the price slippage becomes. Every market will at times experience liquidity problems; however, some markets experience liquidity problems more often. For example, bonds are very liquid, and typically you can get filled within one tick of where you desire to enter the market. Sugar and coffee are very thin markets, and the liquidity can be quite poor. |
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Determining liquidity risk is often difficult. This is because a normally liquid market may experience no liquidity problems for a relatively long period of time. Then an unexpected news event catches the market by surprise, and the liquidity disappears. The best way to determine liquidity risk is by looking at tick charts that encompass several days. This allows you to see the amount of price movement tick by tick. If a tick chart indicates that trading is taking place at intervals of one or two ticks, then the market is demonstrating good liquidity. If trades are taking place at tick intervals of three or more, then the liquidity is poor. The critical assumption is that you are looking at "normal" trading days. Another way to determine liquidity is to look at the volume of contracts that are traded in that particular market. Typically the higher the volume, the more liquid the market. |
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A limit move is an extreme example of a market with no liquidity. Some exchanges place a limit on how much and how far the price may move in one day. A limit move is the result of no one being willing or able to take the opposite side of the trade. Limit move risk is a subset of liquidity risk because the trader, by being on the wrong side of the move, is unable to exit the trade. |
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