Futures market liquidity is an important topic that’s easy to overlook. However, if you’re going to prosper as an active trader, then understanding the concepts of market depth and order flow is critical. Let’s take a closer look at the leading factors that affect futures liquidity.
Deep vs. Thin Markets
In general, liquidity is a measurement of how easy it is to exchange one type of asset for another. As it pertains to the futures markets, liquidity reflects the efficiency by which contracts are bought and sold.
In practice, futures market liquidity is a product of the ongoing dialogue between buyers and sellers. As market participants send orders to the market, the ability for a given contract to change hands quickly at a stable price is impacted. Subsequently, markets come in two basic varieties: deep and thin. Here’s a quick look at each type.
Deep
A deep futures market features heavy participation, consistent order flow, and no shortage of buyers and sellers. These elements promote trade-related efficiency and constant pricing volatility. As a general rule, deep markets are related to assets in the public eye.
Thin
Thin futures markets are those that experience lagging participation and limited order flow. These contracts are a challenge to trade due to choppy price action and wide bid-ask spreads. Slippage is a major concern in thin markets because entering and exiting trades efficiently can be a formidable challenge.
Deep, active markets are target-rich environments for active traders. When a contract is being frequently bought and sold, trade-related efficiencies and periodic volatilities are enhanced. As a result, positive expectation trading opportunities become more common because the negative influences of slippage and sudden volatility are minimized.
Addressing Futures Market Liquidity
For many active traders, finding liquid markets is job No. 1. Fortunately, this task may be routinely accomplished by simply looking at several indicators:
Traded Volumes
Average traded volumes represent the number of contracts that have changed hands in a market over a given period of time. For instance, the E-mini S&P 500 regularly trades more than 1 million contracts in a given day.
Open Interest
Futures market open interest is the total number of contracts held by market participants at the end of a trading day. From a practical standpoint, the greater the open interest, the greater the forthcoming market liquidity.
Trading Ranges
A contract’s periodic pricing fluctuations can be a signal of market liquidity. If order flow remains heavy, then an intraday, day, or weekly trading range is more likely to become extended. Although this phenomenon can occur in thin markets, it typically develops in those experiencing robust participation.
Large traded volumes, open interest, and extended trading ranges are signs that a market is liquid. Here are a few of the most consistently liquid contracts offered by the Chicago Mercantile Exchange (CME):
| Asset Class | Liquid Contracts |
|---|
| Agriculture | Corn (ZC), Soybeans (ZS), Wheat (ZW, KE) |
| Metals | Gold (GC), Copper (HG) |
| Energies | WTI Crude Oil (CL), Henry Hub Natural Gas (NG) |
| Equities | E-mini S&P 500 (ES), E-mini NASDAQ (NQ) |
| Currencies | Euro FX (6E), Japanese yen FX (6J) |
It is important to remember that the futures products with the highest liquidity are known as “front-month contracts.” A front-month contract is one that is close to expiration. When compared to “back-month” or “far-month” contracts, market depth, liquidity, and public interest are typically greater.
For instance, the E-mini S&P 500 is listed for trade quarterly, with the contract months of March, June, September, and December. Accordingly, the nearest month to the present represents the front-month contract and greatest futures market liquidity. This listing will be more liquid than back-month issues, which will likely feature reduced market depth and order flow.
FAQs
Liquidity refers to the degree of ease with which an asset such as a futures contract can be bought or sold in a timely manner, and the costs associated with that transaction.
How does liquidity affect the market? ›
Market liquidity is important for a number of reasons, but primarily because it impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as there is usually always someone willing to take the other side of a given position.
What is market impact and liquidity? ›
The extent to which the price moves is a reflection of the liquidity of the asset: the more liquid the asset, the less any one trade will affect its price. Trading an asset can also affect the prices of other assets, a phenomenon known as cross impact.
How does liquidity work in trading? ›
The Liquidity definition refers to the extent to which a particular asset can be bought or sold quickly on the market without having a significant effect on its price. Liquidity is an important factor that investors assess when making their trading decisions since it has an effect on their trades.
What is the liquidity risk of a futures contract? ›
Liquidity risk is the risk of not being able to find a counterparty to a trade at a fair market price. The advantage of futures contracts is that the contracts are all standardized. By having standard contracts it is easier to find multiple interested counterparties.
Why is liquidity good for markets? ›
Liquidity drives all financial markets. Markets with high liquidity encourage rapid buying and selling, which stimulates the economy. On the other hand, markets with low liquidity can stall a market and drive up prices. Whether you're trading stocks or cryptocurrencies, you should be mindful about what liquidity is.
How does liquidity affect market prices? ›
Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly.
What is liquidity and why is it important? ›
Liquidity is how easily an asset can be converted into cash and be spent. Every asset and investment requires finding a market if you decide to sell it—whether it's the stock market, where selling a stock or mutual fund is usually fast and simple, or the more complicated world of finding a buyer for real estate.
What is the impact of high liquidity? ›
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
What is an example of a liquidity effect? ›
Suppose that a monetary authority increases the money supply by conducting an unexpected outright purchase of bonds (an open market operation). At short horizons, nominal interest rates fall so that households are willing to hold a smaller quantity of bonds and a larger quantity of money.
Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities. How much cash could your business access if you had to pay off what you owe today —and how fast could you get it? Liquidity answers that question.
What is an example of liquidity in trading? ›
Examples of liquidity
For instance, with a daily trading volume of over $5 trillion, forex is considered the largest and most liquid market in the world. Large stock markets, such as the New York Stock Exchange, are also considered highly liquid because thousands of shares change hands every day.
How does the market gain liquidity? ›
A stock market is categorised to be liquid due to the existence of a high number of buyers and sellers. One can sell off their owned stocks quickly through electronic markets. Thus, according to the demand, an individual or business can convert equity securities into cash quickly.
How to measure liquidity futures? ›
Liquidity for equity index futures is often measured by what investors can see quoted or traded on-screen. If the central limit order book (or CLOB) displays a wide bid-ask spread or shows small size, a market participant may incorrectly conclude that the contract is illiquid.
What is market liquidity in simple terms? ›
Market liquidity describes how easily assets may be purchased and sold in a market, including the stock exchange of a nation or the real estate market of a city, at predictable, open prices.
What does liquidity mean? ›
Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities. How much cash could your business access if you had to pay off what you owe today —and how fast could you get it? Liquidity answers that question.
Does liquidity mean volatility? ›
A market's liquidity has a big impact on how volatile the market's prices are. Lower liquidity usually results in a more volatile market and cause prices to change drastically; higher liquidity usually creates a less volatile market in which prices don't fluctuate as drastically.
