Friday Fun Fact: How Traders Measure Liquidity

The investment community usually defines a liquid investment as something that can be easily turned into cash.  Selling a house is an example of an illiquid investment.  It could take weeks or months to close on the transaction and receive your money.  Stocks, however, tend to be very liquid because they can be sold on a moment’s notice. Moreover, you can sell large amounts of stocks in seconds and receive your money rather quickly.

Unlike the investment community, futures traders measure liquidity in terms of how easy it is to buy and sell the futures contracts they are interested in. They usually use volume, open interest and a narrow bid/offer spread as primary gauges of liquidity. Futures contracts like U.S. Treasuries and Eurodollars trade millions of contracts a day and have open interest exceeding 1,000,000 contracts or more.

Additional gauges of liquidity would involve examining the depth of order book, how many contracts are bid for and how many are offered (often referred to as size). A futures contract that is one up (one contract bid for and one on the offer) is much less liquid than a contract that is one tick wide and 100-up (100 on the bid and 100 on the offer). Some new, or less liquid, futures contracts might have bid offer spreads of several ticks or more and are only a one-up market.

Traders tend to gravitate toward futures contracts where liquidity is optimal, thus reducing slippage, a primary part of overall transaction costs.