Liquidity risk
Liquidity is the number of willing buyers and sellers in the underlying at any one point in time. If either were to disappear completely there would be no market.
There are lots of reasons liquidity drys up in a market – it is anything that creates uncertainty.
If there is low liquidity, brokers are less certain about the prices they are quoting and, if they have a variable spreads offering, might widen the spreads to reflect this. When this happens it makes it more expensive to trade – suddenly they have to pay more in Spread, and if they have an open position they have to exit they have little choice than to trade at the wider spread. All markets have periods of expected low liquidity, overnight for example. This real risk here, for a trader that knows a market, is when there is an unexpected period of low liquidity bringing an unexpected increase in trading costs.
It is rare but on occasions, markets have no liquidity, this is when buyers and sellers become so uncertain they step away completely and trading is suspended. During the period the market is closed a trader cannot open or close a position, even with orders – they can only trade when it next reopens. If they had an open position and the price goes against them upon reopening, and remember they can’t trade out of it until it reopens, it could lead to big hit upon reopening. This happened to some unfortunate traders back in 2015 when the Swiss Franc unpegged from the Euro, there is an article explaining the fallout in our materials tab at the top of the page.
Most of the time, especially if you trade highly liquid markets like major FX or indices during trading hours then you won’t notice this risk. If you trade illiquid markets like small-cap equities or if you trade overnight you might see this risk impact your cost of trading quite a bit.
Traders can manage the risk of unexpected low liquidity by trading with a fixed spreads broker. They can partly manage the risk of no liquidity by trading highly liquid markets but as the Swiss Franc showed, it is a risk that can not be mitigated entirely.
- Liquidity is the number of willing buyers and sellers in an underlying market.
- If there is low liquidity, variable spread brokers are less certain about the prices they are quoting so might increase spreads to compensate. This makes it more expensive to trade.
- Traders can manage the risk of unexpected low liquidity by trading with a fixed spreads broker.
- Traders can partly manage the risk of no liquidity by trading highly liquid markets.
- Liquidity risk can never be fully mitigated.
