How to deal with low liquidity assets

Low liquidity can be hard to deal with. One of the most striking examples of least-traded high-value assets is Vincent van Gogh’s Portrait of Dr. Gachet. In 1990, the painting was sold at auction and became one of the most expensive paintings ever sold. But then, it’s been publicly offered for sale twice since that auction, and both times it failed to sell. 

Managing low liquidity assets requires a different approach than more traditional ones, and traders need to be prepared to navigate the challenges that come with them. But here is how you can navigate this unique trading landscape with confidence.

What is liquidity?

Liquidity measures the ease with which an asset can be bought or sold in the market. Cash is the king of liquidity, as it’s the most flexible and widely accepted asset in the market. Its ability to facilitate quick and seamless transactions makes it the ultimate medium of exchange, accepted by merchants and consumers worldwide. 

In contrast, physical assets like real estate, art, and collectibles are considered relatively illiquid. This means that finding buyers and selling these assets quickly can be quite challenging, and it often requires significant discounts on the market value. 

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Financial assets like stocks, bonds, and currency pairs have varying levels of liquidity depending on the demand for them in the market. Highly sought-after stocks of large, well-established companies, for example, may be easier to buy and sell quickly. At the same time, smaller or less-known companies’ stocks may have lower liquidity. 

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High and low liquidity

Both high and low liquidity have advantages and disadvantages depending on the context. High liquidity tends to offer greater flexibility and efficiency in trading. As a result, it’s easier to buy and sell assets quickly and with minimal price impact. However, this also leads to lower returns on investments, as more people are competing to buy and sell the same assets, which typically drives prices down.

The upside of low liquidity is that it provides opportunities for higher returns. This tends to happen because there are fewer buyers and sellers competing for the same assets. The downside is the higher risk of not being able to sell the asset when you want. Or you may be forced to sell or buy at a price that is lower or higher than anticipated.

How liquidity can affect your trade

Mary Phillips, deputy head of portfolio management at Dimensional, said in an interview with FT.com: “I think that if you were the kind of asset manager trying to do large block trades quickly and you’re really specific about what you want to trade you could face liquidity challenges.”

Indeed, lower liquidity environments can limit the ability to enter and exit positions quickly, especially if you’re dealing with higher volumes. Even if you’re not an asset manager for a firm, lower liquidity can still have an impact on your personal trading activities. These inconveniences fall into three categories: 

• Difficulty in exiting trades – As mentioned, it might not be possible to exit a trade if the market conditions suddenly change or if you need to free up capital for other purposes. You may end up holding onto positions longer than intended, thus increasing your risk exposure.
• Market impact – In a low liquidity market, trades can have a greater impact on the asset price. If someone else does a big translation, the price can easily move against you, resulting in a worse execution price than you expected.
• Increased trading costs – Trading costs may be higher due to the limited number of buyers and sellers. From the broker’s perspective, it’s harder to find counterparties for their clients’ trades.

The effect isn’t all bad, though. Low liquidity makes it easier to take advantage of market inefficiencies and price discrepancies. Plus, markets are often described as more prone to behavioral biases like herd mentality or panic selling. For contrarian traders, it’s an opportunity to take advantage of market sentiment.

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How to measure liquidity

There are different formulas to measure liquidity depending on the specific asset being traded and the market conditions. Here are a few examples:

Volume

Trading volume = total number of assets traded / time period

When there is a lower trading volume in a market, it usually means that there is lower liquidity. 

Open interest

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Open interest is not a formula but is rather expressed as the total number of outstanding contracts or positions. Lower open interest generally indicates lower liquidity because there are fewer market participants holding positions and willing to buy or sell the asset.

Time to execute

Time to execute is also not a formula—it’s the time between placing the order and trade execution. When the execution times for trades are slower, it is typically a sign of lower liquidity.

Price impact

Price impact = (price after trade – price before trade) / price before trade

When the price impact of a trade is lower, it indicates higher liquidity in the market and vice versa.

It’s important to note that these factors in isolation don’t guarantee high or low liquidity. It’s a combination of different things that ultimately determines liquidity.

Should you trade low liquid assets?

Navigating low liquidity markets can be like steering a ship through rough waters. You need to be prepared to weather the storms and stay in the market for extended periods of time to achieve your desired results. This requires a great deal of patience, discipline, and mental fortitude. 

You will also need decent market knowledge. Without skill and experience, you may not be able to deal with the unique challenges and opportunities presented by these markets. For beginners, unpredictable and volatile are the typical first choices. 

Despite the challenges, trading low liquidity assets can make your efforts worthwhile. Especially for skilled traders, lower competition and fewer market participants can be very rewarding. If you trade a healthy mix of low- and high-liquidity assets, you will be more resistant to market downturns and better positioned for growth.

How to trade low liquid assets

Here are the tactics to maneuver through low liquidity markets:

• Patience is key – It’s all about adopting a long-term view and avoiding the temptation to make hasty decisions that could result in regrettable losses. 
• Be aware of slippage – In a low liquidity market, slippage can be particularly pronounced. So, you should closely monitor the market and stay on the lookout for any sudden changes that could affect the price.
• Use limit orders – With a limit order, you can specify the exact price at which you want to buy/sell. This will help you avoid the pitfalls of slippage and ensure your trades are executed at a fair price.
• Use smaller trade sizes – Holding a large position in an illiquid market is very risky, as the prices can be particularly volatile. Sticking to smaller trade sizes will also minimize the impact your trades have on the market.
• Diversify – As you can tell by now, the risk of getting stuck with an illiquid asset can be high.  Diversification is the way to mitigate this risk by scattering it across multiple assets.

Other than that, the basic trading mechanics are the same. 

Conclusion

It’s important to understand “what is good liquidity” when it comes to trading and the role of “bad” liquidity. When you’re dealing with low liquidity assets, you need to understand the risks involved and be prepared to hold onto these assets for longer periods of time. And even then, you may not be able to buy/sell your assets quickly or at the price you desire. This can be especially challenging during times of market volatility or economic uncertainty. 

However, by taking a long-term view and having patience, it’s possible to ride out short-term fluctuations and potentially realize greater returns over the long haul.

Sources: 

Understanding liquidity and how to measure it, Investopedia‘

Liquidity is terrible’: poor trading conditions fuel Wall Street tumult, Financial Times