Liquidity Has a Direct Effect on the Cost of Execution…
Liquidity is to a greater extent than oftentimes than non understood to live on the grade to which an property (or currency inwards our case) tin displace live on bought together with sold without affecting the toll of the asset. In relation to institutional investors, liquidity is ane of the transcend concerns when deciding which assets to purchase together with sell. An investor’s worst nightmare is to live on caught inwards a seat that he cannot liquidate, or exit. When an investor who is positioned long inwards the marketplace cannot larn out because at that spot are no buyers to which he tin displace offload his position, together with then the marketplace is said to live on illiquid. If markets are non liquid, consummate hysteria tin displace ensue. That’s what happened inwards the autumn of 2008. Markets became thus illiquid that banks stopped lending to each other inwards the overnight interbank market, together with a consummate credit freeze gripped fiscal markets. Suffice to say, illiquidity is no joke if you lot are running large money.
Liquidity together with the cost of execution is a leading argue why the unusual telephone substitution marketplace is thus attractive to large lodge traders. It is past times far the most liquid marketplace inwards the world. With a daily turnover of over $3 trillion, liquidity is to a greater extent than oftentimes than non available. However, at that spot are silent cases inwards which notable hedge funds larn caught inwards large positions inwards exotic currencies that they cannot larn out of. Imagine beingness long a few one 1000 contracts, toll is moving against you lot every day, together with you lot can’t larn out! That would live on the worst feeling inwards the world!
This scenario truly played out concluding twelvemonth at the largest currency-only hedge fund inwards the world, FX Concepts. FX Concepts finished 2011 downward -19% on the year. I read an interview inwards the belatedly autumn amongst the possessor John Taylor, together with Taylor discussed how the theatre had taken pregnant positions inwards the Brazilian existent that moved against them substantially, together with they could non liquidate the positions.
Liquidity together with the Cost of Execution
I desire to intermission downward a few primal points that are of import to sympathise regarding liquidity. Now, you lot are most probable never going to bargain amongst liquidity issues. In the spot fx market, you lot tin displace typically uncovering liquidity for upward to $20 ane one 1000 thousand or to a greater extent than at a given toll amongst a reputable Prime Broker. However, if you lot sympathise the nature of liquidity together with the goal of large lodge traders, you lot tin displace ride their coat tails. In my experience, this tin displace plough over you lot a greater border inwards your trading because you lot volition sympathise why toll is moving the way it is moving. Let’s run through a few primal points.
Large Order Traders Need Liquidity
Institutional participants together with large lodge traders (those who are pushing through >$20 ane one 1000 thousand per click) to a greater extent than oftentimes than non cannot execute at whatever given toll on the chart. This is where institutional together with retail traders receive got a markedly unlike experience. If you lot are amongst a character ECN or DMA broker, you lot tin displace move inwards together with move out trades at whatever price, whatever time, amongst a really tight spread. You should receive got really footling or no slippage, equally long equally you lot are trading a few ane one 1000 thousand or less per click. This is non the instance amongst these large lodge traders. Their cost of execution is non equal at all prices.
For example, imagine amongst me that EUR/USD is making a rigid movement upward from 1.3206 to 1.3250. At every fractional pip, at that spot is a for sure amount of liquidity available. Let’s assume that $15 ane one 1000 thousand is available at 1.3206. As presently equally that $15 ane one 1000 thousand is bid, together with then toll volition movement upward to the side past times side available expanse of liquidity. If markets are extremely liquid, such equally during the NY together with London sessions generally, the side past times side expanse of liquidity mightiness live on simply a fraction of a pip higher at 1.32065. This is how toll moves all 24-hour interval long. Now, hither is the entire point—there volition live on to a greater extent than liquidity at areas of pregnant technical confluence. At areas where a trendline, a Fibonacci level, a major moving average, a primal psych figure (20, 50, 80, 00), etc. all encounter up, at that spot volition live on a higher than normal cluster of trammel together with halt orders. This leads to a deeper puddle of liquidity, together with this is really of import to understand. Large lodge traders (those who truly movement price) volition live on incentivized to force toll into these areas inwards lodge to execute at the lowest cost possible. Breaking Down The Math
Let’s tell that Bob the Institutional Trader wants to execute an lodge for $75 ane one 1000 thousand curt on EUR/USD. Bob volition live on incentivized to watch toll movement into an expanse of heavy technical confluence because he may live on able to execute his entire lodge at a unmarried price, or at worst he may larn slipped a fractional pip. In other words, Bob’s fills may await similar this:
However, if Bob had tried to execute this merchandise for $75 ane one 1000 thousand at a random price, his fills may receive got looked similar this:
Now, let’s intermission downward the mathematical divergence betwixt the 2 pairs. In the institutional world, CTAs together with other large lodge traders volition typically live on paying to a greater extent than or less $30 per ane one 1000 thousand inwards traded book summation the spread. Lots of retail traders tend to scream back that institutional traders are seeing insanely tight spreads, but the reality is they are non seeing much tighter spreads than you lot tin displace larn at a good, retail ECN or DMA broker. Bob was executing a merchandise of $75 ane one 1000 thousand on EUR/USD, together with his typical spread on EUR/USD is 0.5 pips. That agency that Bob’s cost of execution is going to be:
$30 x $75 ($30/million commission) = $2,250
0.5 pip spread = $50 per ane one 1000 thousand = ($50 x $75) = $3,750
————————-
Total Cost to Bob = $6,000
Thus, Bob spent $6,000 to execute this merchandise of $75 ane one 1000 thousand inwards our showtime example. Now, let’s receive got a await together with watch how much slippage or illiquidity costs a large lodge trader. In our instance above, Bob was slipped solely 0.5 pips inwards the showtime scenario. In the instant scenario, however, Bob is slipped 1.5 pips.
This agency that Bob’s transaction cost on the spread side of the equation volition live on $9,900 due to inefficient execution, which is an increased cost of $3,900! On a per centum basis, that is 65% increment to Bob’s initial execution when he was filled at a favorable price. That $3,900 differential makes a huge divergence to Bob’s bottom business together with to his firm. That’s plenty to pay Bob’s secretarial assistant for at to the lowest degree ane month!
Now, hopefully you lot tin displace watch why large lodge traders are incentivized to force toll into primal areas where at that spot volition live on a higher than normal cluster of orders. If they tin displace accumulate positions or liquidate positions at toll levels which receive got deep liquidity, together with then their cost of execution is considerably lower.
In a hereafter article, nosotros volition beak virtually how to piece of job this noesis when constructing your strategy together with approach to the market. However, I’ll leave of absence you lot amongst this thought:
If you lot seat an expanse of really clear back upward or resistance on a higher timeframe, what exercise you lot scream back large lodge traders are going to desire to exercise equally presently equally toll gets inside 20-30 pips? They, of course, are going to live on incentivized to force toll into the level. Accordingly, you lot tin displace receive got wages of that.