From the February 01, 2010 issue of Futures Magazine • Subscribe!

For CTAs, more volume doesn't equal liquidity

When researching whether to trade a market, the most important factor for commodity trading advisors (CTAs) is liquidity. Volume and open interest are perhaps the best tangible measures of liquidity but they aren’t the same thing as liquidity. This is best measured by the ease with which a trader can execute high volumes at one price without causing the market to move against them, or slippage.

When commodity markets made the transition a couple years ago to electronic platforms from open outcry, it led to increased volume and open interest. But despite added volume, some CTAs have noticed that it has not been as easy to execute large orders. And if those CTAs had models that called for them to enter on stops, there was added danger. When stops are initiated and there are no standing orders in queue, the market can move against you rapidly.

This is less of a problem in the ultra liquid financial markets, but all other markets are affected. “The less liquid a market is, the more apt you are to fish out a stop and run something,” says Jon Thompson, VP of trading at Fall River Capital. “It is kind of tough in the bonds or the S&Ps to fish out a stop. But certainly ags, energies and some of the markets that are less liquid, if you fish stops out then they run.”

Most managers we speak to either use stop limits or have eliminated the use of stops altogether. If their entries are triggered by price ala a stop, managers will execute orders with discretion rather then face a possible cascading stop environment. “I don’t use stops. I would rather take the risk of having to rework the order than I would of having a stop that is significantly away from my risk parameters,” says CTA Gordon Linn.

CTA Richard Crow says, “I find the electronic system has created more volatility to the markets. The executed orders that we have to live with are not as good as what we would have experienced three years ago.”

Linn adds, “These are not necessarily high volatility markets, but they are high velocity markets. The point is when you can’t control your risk, you reduce size because you have to control the number of dollars you are going to use.”

WHY less liquid?

Since most markets have seen an uptick in volume, the question is why hasn’t that helped liquidity. A look at an electronic market gives you a clue (see “Is that all there is?”). At any give time, there is not a lot of size shown. Some bids and offers could represent traders willing to do more but unwilling to show it, but you don’t know. They could also represent stops with more size that could cause a big move.

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