The Benefits of Liquidity

The Benefits of Liquidity

Liquidity is perhaps one of the most important elements in gauging opportunities in a market.

At its core, liquidity is the collective expression of traders' opinions on the market.

Like any other market, these opinions are represented in a futures market either as existing positions held by traders, known as open interest, or as buy or sell orders communicated to the rest of the market but yet to be executed.

The size and price of these orders may vary considerably, but the key element to consider is that the more opinions that are expressed in the market, the more liquid the market is.

Liquidity is such an important element of market opportunity because the more participants there are, the more expressions of opinion on the market, the greater the likelihood that a single trader, like yourself, will encounter another with an opposing viewpoint that results in you both agreeing on a quantity and price to trade. 

Example

Compare the Natural Gas (NG) futures market to the U.S. natural gas (UNG) ETF market. One NG contract is equivalent to 10,000 mmbtu of natural gas exposure. At a price of $2.722 per mmbtu, the notional, or dollar, value of a single contract is $27,220.

Notional Value = Price X Contract Multiplier

Notional Value = $2.722 X 10,000 (NG multiplier)

Notional Value = $27,200

At an average daily volume of 322,441 contracts as of fourth quarter 2014, the dollar value total of natural gas futures traded between participants on an average day is just shy of $8.8 billion.

The UNG ETF contract, which tracks the price of natural gas, trades at $13.94 per share. UNG reports an average daily volume of 12,582,300 shares, making the average notional value traded within the market of only about $175 million per day.

Conclusion

Understanding liquidity in a market is a critical consideration for traders before jumping into a trade. Futures markets offer deep liquid markets that let traders express their opinions in a tremendously efficient way.