notes-finance-liquidity

random ideas about liquidity. Probably all wrong.

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Liquidity has to do with bid/ask spreads, and the word 'liquid' suggests a phase transition such as from solids to liquids (or gasses to liquids), and 'liquid' is often used in a binary sense, eg "this is a liquid market" "this is an illiquid market". Can we be more specific?

Here's a guess. An illiquid market is one where the bid/ask spread represents an impatience penalty. The price you pay to the spread can be reduced if you are patient. If you can stand to wait an hour, or a week (or a year) for an eager counterparty to happen by, then you should do so; you'll probably end up getting a significantly better deal than if you pay the spread and execute the transaction right now. Placing a primary pegged order (eg if you want to buy, placing an order at the bid), possibly hidden, or a hidden order at or near the midpoint, are reasonable things to do. Placing a limit order at the market price (eg if you want to buy, the lowest ask) is probably a waste of money if you can afford to wait.

A liquid market is one when you gotta pay the spread; there is no gain to waiting, EVEN IF you are not in a hurry. If you wait around for someone to cross the spread, or cross half the spread, the risk of the market moving away from you almost exactly compensates for the money you would save on the spread. Placing a limit order at or close to the market bid would not be a bad idea. On the other hand, placing an order on your side of the midpoint might be a bad idea; the risk of adverse selection (your trade is more likely to execute if an better-informed counterparty thinks the price is about to move) might outweigh the money you think you are saving on the spread. In a liquid environment, the spread represents price uncertainty and the cost of adverse selection, and any attempt to not pay the full spread is equivalent to trying to beat the market, which means that you are betting against Mr. Market and will probably lose the bet and pay more than if you just accepted the spread.

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