Liquidity and the Cost of Execution

Liquidity Has a Direct Effect on the Cost of Execution…

Liquidity is generally understood to be the degree to which an asset (or currency in our case) can be bought and sold without affecting the price of the asset. In relation to institutional investors, liquidity is one of the top concerns when deciding which assets to buy and sell.

An investor’s worst nightmare is to be caught in a position that he cannot liquidate, or exit. When an investor who is positioned long in the market cannot get out because there are no buyers to which he can offload his position, then the market is said to be illiquid. If markets are not liquid, complete hysteria can ensue. That’s what happened in the fall of 2008. Markets became so illiquid that banks stopped lending to each other in the overnight interbank market, and a complete credit freeze gripped financial markets. Suffice to say, illiquidity is no joke if you are running big money.

Liquidity and the cost of execution is a leading reason why the foreign exchange market is so attractive to large order traders. It is by far the most liquid market in the world. With a daily turnover of over $3 trillion, liquidity is generally available. However, there are still cases in which notable hedge funds get caught in large positions in exotic currencies that they cannot get out of. Imagine being long a few thousand contracts, price is moving against you every day, and you can’t get out! That would be the worst feeling in the world!

This scenario actually played out last year at the largest currency-only hedge fund in the world, FX Concepts. FX Concepts finished 2011 down -19% on the year. I read an interview in the late fall with the owner John Taylor, and Taylor discussed how the firm had taken significant positions in the Brazilian real that moved against them substantially, and they could not liquidate the positions.

Liquidity and the Cost of Execution

I want to break down a few key points that are important to understand regarding liquidity. Now, you are most likely never going to deal with liquidity issues. In the spot fx market, you can typically find liquidity for up to $20 million or more at a given price with a reputable Prime Broker. However, if you understand the nature of liquidity and the goal of large order traders, you can ride their coat tails. In my experience, this can give you a greater edge in your trading because you will understand why price is moving the way it is moving. Let’s run through a few key points.

Large Order Traders Need Liquidity

Institutional participants and large order traders (those who are pushing through >$20 million per click) generally cannot execute at any given price on the chart. This is where institutional and retail traders have a markedly different experience. If you are with a quality ECN or DMA broker, you can enter and exit trades at any price, any time, with a very tight spread. You should have very little or no slippage, as long as you are trading a few million or less per click. This is not the case with these large order traders. Their cost of execution is not equal at all prices.

For example, imagine with me that EUR/USD is making a strong move up from 1.3206 to 1.3250. At every fractional pip, there is a certain amount of liquidity available. Let’s assume that $15 million is available at 1.3206. As soon as that $15 million is bid, then price will move up to the next available area of liquidity. If markets are extremely liquid, such as during the NY and London sessions generally, the next area of liquidity might be just a fraction of a pip higher at 1.32065. This is how price moves all day long. Now, here is the entire point—there will be more liquidity at areas of significant technical confluence. At areas where a trendline, a Fibonacci level, a major moving average, a key psych figure (20, 50, 80, 00), etc. all meet up, there will be a higher than normal cluster of limit and stop orders. This leads to a deeper pool of liquidity, and this is very important to understand. Large order traders (those who actually move price) will be incentivized to push price into these areas in order to execute at the lowest cost possible.

Breaking Down The Math

Let’s say that Bob the Institutional Trader wants to execute an order for $75 million short on EUR/USD. Bob will be incentivized to see price move into an area of heavy technical confluence because he may be able to execute his entire order at a single price, or at worst he may get slipped a fractional pip. In other words, Bob’s fills may look like this:

However, if Bob had tried to execute this trade for $75 million at a random price, his fills may have looked like this:

Now, let’s break down the mathematical difference between the two pairs.  In the institutional world, CTAs and other large order traders will typically be paying around $30 per million in traded volume plus the spread.  Lots of retail traders tend to think that institutional traders are seeing insanely tight spreads, but the reality is they are not seeing much tighter spreads than you can get at a good, retail ECN or DMA broker.  Bob was executing a trade of $75 million on EUR/USD, and his typical spread on EUR/USD is 0.5 pips.  That means that Bob’s cost of execution is going to be:

$30 x $75 ($30/million commission) = $2,250

0.5 pip spread = $50 per million = ($50 x $75) = $3,750

————————-

Total Cost to Bob = $6,000

Thus, Bob spent $6,000 to execute this trade of $75 million in our first example.  Now, let’s take a look and see how much slippage or illiquidity costs a large order trader.  In our example above, Bob was slipped only 0.5 pips in the first scenario.  In the second scenario, however, Bob is slipped 1.5 pips.

This means that Bob’s transaction cost on the spread side of the equation will be $9,900 due to inefficient execution, which is an increased cost of $3,900!  On a percentage basis, that is 65% increase to Bob’s initial execution when he was filled at a favorable price.  That $3,900 differential makes a huge difference to Bob’s bottom line and to his firm.  That’s enough to pay Bob’s secretary for at least one month!

Now, hopefully you can see why large order traders are incentivized to push price into key areas where there will be a higher than normal cluster of orders.  If they can accumulate positions or liquidate positions at price levels which have deep liquidity, then their cost of execution is considerably lower.

In a future article, we will talk about how to use this knowledge when constructing your strategy and approach to the market.  However, I’ll leave you with this thought:

If you identify an area of very clear support or resistance on a higher timeframe, what do you think large order traders are going to want to do as soon as price gets within 20-30 pips? They, of course, are going to be incentivized to push price into the level.  Accordingly, you can take advantage of that.