For the past several sessions I have been harping consistently about liquidity in the markets. More exactly about the lack of liquidity we are experiencing right now so I want to use this opportunity to dispel some misconceptions about what liquidity really is. The most important takeaway from this post is that liquidity is not volume.
I know that some of you might be puzzled by my assertion that we haven’t had any meaningful liquidity the past couple of sessions when in fact trading volume has been 3X or 4X higher than usual. How is that possible ? Well the answer is that volume and liquidity are two very different beasts. Volume is just that, the amount of shares, or contracts traded in a given timeframe. This is a concept that is simple to understand and visualize. But what is then liquidity ?
To understand what liquidity is in modern markets we need to understand the work of Market Makers and liquidity providers (please forgive the circular definition). There is this common misconception that for any given trade in the market we have two sides. One side betting that the market will go up and the other side betting that the market will go down. This is erroneous because in modern markets we have a middle man, there is a set of market participants that don’t care where the market is going and they make a two sided market at every tick (offering to buy, and offering to sell simultaneously) so when organic buyers and sellers arrive they always have an order ready waiting for them and the market functions smoothly.
Imagine for a second that the middle man doesn’t exist, so when a buyer arrives at the market the market is empty, he puts a buy order and has to wait until a seller appears, and of course the seller will be looking for a higher selling price and it will take quite some time for that buyer and seller to agree on a final price (the transaction might never happen). So as you can see the work of that middle man is very important because he is providing “liquidity” (still circular definition). This middle man is willing to take buy and sell orders so the trades can happen faster. How do they make money if they are taking both sides ? Well there is a whole statistical framework that shows that market makers (the middle man) will make money under most conditions independent of market direction (they just need a balanced order flow). The important thing about market makers is that thanks to them you can buy and sell rather quickly and at decent prices compared to the last transaction.
As you can imagine a single market maker can’t take infinite trades because he is constrained by capital and risk management. So the more market makers you have in your market the better. In a world class market there are many market makers with huge amounts of working capital willing to take orders of any sizes. The more market makers there are and the more order flow they can take on the more liquid a market is. In this kind of market trading happens very smoothly no matter what size you are trading, and transactions are filled in very short periods of time. Better yet, trade price is very stable as the order book is fat and there will always be someone willing to make you a market.
So there you have it, liquidity in a market is a measure of how many middle-men the market has and how well capitalized they are. During a real trading session there are many more types of liquidity providers, in addition to market makers we have high frequency traders, algorithmic funds, and of course our GammaOptimizer room :) because believe or not we are always liquidity providers in the options space (just think about it hard and you will see why).
Now coming back to my argument from the last couple sessions. What happens when liquidity evaporates ? Exactly what we have seen this week, then the middle-men disappear (or are greatly reduced in numbers and capital) most trades will start happening directly between buyers and sellers and that is very problematic because organic buyers and sellers are always far apart in price. Not only that, buyers and sellers can absorb only a fraction of what a normal market maker can do, so when a big seller finds a buyer, only a fraction of size is moved and then he needs to find another buyer that will be even farther in price and trade price starts to decrease in huge amounts rather quickly (the same happens when there is a big buyer). So in an iliquid market price varies wildly in huge swings because the fractional liquidity provided by organic buyers and sellers disappears in a heartbeat. That is why intraday realized volatility can be a very good measure of liquidity: When realized volatility is very high (like right now) it means that liquidity is being dried very quickly (sellers exhausting buyers or vice versa) which is a sign that market makers are not operating at full capacity or not operating at all.