Rising tension from the U.S.-China trade spat and the related drop in bond yields has lead to another surge in market volatility in recent weeks. When negative market sentiment becomes pervasive, investors typically seek smaller positions in the market which can, in turn, lead to lower market liquidity.
So what is liquidity? Volatility?
Liquidity is the degree to which an asset can be quickly bought or sold in the market at a price reflecting its actual value. Strong liquidity means it's easy to buy or sell quickly at current market prices.
Volatility, is the tendency for returns to vary around their average. Volatility is a normal part of global stock markets as investors react to the latest information (economic conditions, geopolitical events, policy maker action, individual stock events etc.).
One key measure of market liquidity is the S&P 500 futures market. To measure volatility, we have the CBOE Volatility Index (VIX), which measures expected price fluctuations in the S&P 500 Index options over the next 30 days. Often dubbed the “fear index", the VIX is calculated in real time by the Chicago Board Options Exchange.
Economic growth indicators like the price of consumer goods and services, or U.S. manufacturing data, along with unemployment and inflation are still an important part of understanding baseline volatility. That said, the increase in volatility between 2017 and 2018 was much greater than expected. Goldman Sachs research, The Rising Importance of Falling Liquidity, suggests that the VIX spike observed in February 2018, is likely explained by general risk aversion among investors.
Liquidity is the backbone of an efficient market place
Liquidity is extremely important when considering your trading positions and your ability to exit them. Liquidity is essential if you are aiming to efficiently get in and get out of the markets.
While market orders move prices less in highly liquidity environments, trading in a less liquid environment where multiple traders are sending the same order, can result in sharp market price movements. This is what happens during a flash crash when everybody is trying to execute trades in an urgent manner.
Studies have found that there is a strong negative relationship between the VIX and the futures market. Why? A jump in volatility can trigger trading program algorithms that systemically sell off securities in response to such news, thus lowering liquidity even more. The effect can be an overly dramatic impact on prices, particularly when a lot of other investors, whose numbers would normally provide liquidity, choose to stay on the sidelines.
With the proliferation of these fast to react programs, traders can find themselves in situations where everyone is buying or selling at the same time, creating price shocks. A market crash caused by a dramatic decrease in liquidity stemming from algorithmic trading is a reality we must consider.
Volatility is inherently part of a healthy market
Volatility is not necessarily a bad thing. As I said earlier, it is normal and we see it everyday—it's unrealistic to expect markets to go up constantly. Market movement fixes pricing anomalies and even creates investment opportunities. However, like many things in life, too much volatility can be unhealthy.
The key element to consider with volatility is its ability to affect the risk management strategy of your trading plan. If you are in small markets with high volatility, you should seriously consider trading in a smaller amount and take a conservative approach to limit any potential losses from sudden and unexpected moves.
While great for the news, at this time, we are not overly concerned about the latest bout of reduced liquidity and increased volatility. As always, we will continue to monitor global economic conditions and adjust our strategy if necessary. For more information, please contact your MD Advisor*.
*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.