There are three key features traders will look for when considering entering a new market. Does the market offer a tight bid/offer spread? Is it liquid? What are the trading hours?
Tight bid/offer
A tight bid/offer spread lets you buy or sell at a reasonable price whenever you want to make a trade. In the futures markets, reasonable price means one that is close to the last traded price.
Liquidity
Without liquidity, i.e., plenty of volume coming into the market, both buyers and sellers find it difficult to establish a fair price at which to trade.
Liquid and illiquid markets tend to be self-perpetuating. Liquid markets draw further, unneeded liquidity because they are liquid. Illiquid markets, by contrast, stay illiquid because market makers and market takers are reluctant to trade them and provide liquidity.
There are two key drivers of the liquidity engine:
- Need for immediacy.
- Supply of immediacy.
An example of the need for immediacy is when a seller determines that it is more sensible to dispose of an asset rather than hold it in a portfolio. The price at which the seller is willing to sell is a function of volatility and the risk involved in holding that asset balanced against the immediate benefit gained by closing out the position. In order to get a price that justifies the sale, the seller looks to the market maker to provide a reasonable bid. The price risk that the seller wants to eliminate is then transferred to the market maker when the trade is made.
Market makers also incur the opportunity cost of acting in this capacity, i.e., the use of capital required for market-making. In the end, the market maker’s view on the riskiness of a potential trade primarily determines the width of the bid and offer simultaneously provided.
The conditions for a liquid market are present when the demand for immediacy is high and the cost of continuous market-making is low.
Accessibility
Most futures contracts trade nearly around-the-clock, which allows traders to express their market opinion at any given time.
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