FIMS: Volume & Liquidity in Trading

FIMS, or "Fundamental Ideas Made Simple," is a series of posts I will be writing to help new traders understand core concepts in trading. The goal is to provide informative content that is more enjoyable to read than a textbook. This article is a technical write-up that details what volume and liquidity are in trading and why they are significant. We will explore these fundamentals by applying them in microcap trading later on because they help simplify the main ideas. Microcaps are assets or companies with small, or micro, market capitalizations. They are much riskier to trade and invest in.

Many tend to associate day traders with trading microcaps, which generally refer to penny stocks in the stock market or altcoins in cryptocurrency. This association has been exacerbated throughout modern history, from the sensational depiction of penny stocks in major blockbusters like "The Wolf of Street" to the explosive media coverage of meme stocks and altcoins like GameStop, AMC, Dogecoin, and Shiba Inu coin. However, two important variables are often overlooked when observing and discussing these high-risk assets.

Rarely do the films and articles mention the consideration of volume and liquidity in microcaps. The two variables are often grouped with other factors, such as high volatility, that make the asset class high risk. However, it is crucial for new traders to understand the influence of volume and liquidity in the trading world. New traders also tend to have higher risk tolerances, which results in a higher likelihood of trading microcaps. This further emphasizes the importance of understanding these fundamentals since microcaps are more likely to face volume and liquidity issues than medium and larger-cap assets. We will later explore the volume and liquidity risks linked to microcaps with a detailed example.

The main topics that will be covered include:

• What is volume?
• What is liquidity?
• What is slippage?
• How are these ideas related to trading?
• Example application (conceptual story)

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What is Volume?

Volume refers to the number of shares, contracts, or units traded in a particular security or market over a given period. It is often used to measure market activity and can help traders identify trends and potentially profitable trading opportunities. For example, if the volume of a particular security is increasing, it may indicate strong demand for the asset and that it is likely to trend upwards. Conversely, if the volume of a particular security decreases, it may indicate weak demand and that the asset is likely to trend downwards. The more an asset is traded, the more volume it has. Naturally, Bitcoin or Apple stock would have more volume than a penny stock or altcoin the overwhelming majority of the time.

What is Liquidity?

Liquidity refers to the ability of a market or security to be bought or sold without significantly affecting the price. A market or security with high liquidity can be easily bought or sold without causing significant price movements. High liquidity is typically associated with high volume and low spread. The higher the volume an asset has, the more liquid it typically is. Using the same comparison as earlier, Bitcoin and Apple naturally have more liquidity than penny stocks. The spread of an asset is the difference between the asset's bid and ask prices. Low spreads can make it easier for traders to enter and exit trades, as they are less likely to incur large losses due to slippage.

What is Slippage?

Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed. It can occur for a variety of reasons, predominantly from a lack of liquidity in the market. However, a delay in the execution of the trade and general market volatility are also potential factors. Slippage can be either positive or negative, depending on whether the trade is executed at a better or worse price than expected. However, it is generally seen as a negative because it can result in a trade being executed at a less favorable price than the trader intended. Additionally, uncertainty is viewed as a risk in the financial markets. In other words, avoiding slippage is typically preferred. On another note, trading microcaps risk losing money more than trading Apple stock and Bitcoin due to high slippage. This is due to microcaps having lower volume and liquidity in comparison, as mentioned earlier.

How Are These Ideas Related to Trading?

Understanding volume and liquidity is essential for traders, as they typically hold positions for short periods and must be able to enter and exit trades quickly. If a market or security has low liquidity, it may be more difficult for traders to buy or sell large quantities of the asset without significantly affecting the price. This can make it harder for traders to profit from their trades and can also increase their risk of losses.

In addition to helping traders make informed decisions about when to enter and exit trades, understanding volume and liquidity can also help traders manage their risk. By understanding the liquidity of a particular market or security, traders can better gauge their risk of loss due to slippage and adjust their trade sizes accordingly.

Example Story (Conceptual) in Cryptocurrency Trading:

Below is a story about a man named Eric who is unfamiliar with the risks of volume and liquidity when trading microcap altcoins. Using the concepts above, we will break down a common mistake that new traders make. To note, the example will use exaggerated actions to simplify the ideas.

Richard Burlton

Background

Let's say a fictional microcap "Golden Retriever" altcoin was released last week (let's call it $GRWOOF). Imagine that $ GRWOOF's fundamentals are identical to $ DOGE's and act as a store of value. There is a total supply of one million $GRWOOF.

A few thousand traders and investors online are excited about $GRWOOF and collectively put one million dollars into the asset at $1 per coin when the coin is first publicly traded. As a result, the total market capitalization of $GRWOOF is now one million dollars.

Eric's Entry

We follow up the next day and find out that our friend Eric decided to set a buy order for five hundred thousand $GRWOOF at $2 per coin because he, like the other traders, is very excited. So naturally, many of the initial buyers are enticed by the buy order he put in and decide to sell their coins to Eric.

The recognized market capitalization of $GRWOOF is now two million dollars, with Eric owning half of the supply (500,000 units). We watch as $GRWOOF begins trading at $1.75 after Eric's purchase because traders anticipate more interest after such an enormous buy and try to buy ahead of the next interested buyer. However, the $1.75 asset valuation and ongoing price changes increasingly misled Eric and his potential profit margin. But why?

The Issue

Despite the price pushing higher, Eric realizes that the bids, or the current price buyers are willing to pay, are very few and far between. He failed to analyze the liquidity risk he put himself in when he entered his position. Liquidity risk is the risk of not being able to trade an asset at a given price or size due to a lack of buyers and sellers. In other words, the risk is that loss due to slippage is too high. Since there are little to no buyers unless the asset price is significantly reduced, the spread will naturally become wider, and the asset's slippage will increase.

The most common example of liquidity risk can be found in the housing market. Retail homes are highly illiquid due to their high cost and need for a specific buyer's interest. Therefore, houses often face liquidity risk, which must be considered from an investing and trading perspective. Simply put, if nobody wants to buy your house at a certain price, you would inevitably need to lower it if you wanted it to sell.

Going back to the altcoin example, we can see that Eric is facing a similar issue. However, because he is unaware of liquidity risk, he still thinks he is on track to make a profit. In his mind, if the price of $GRWOOF reaches $4, then he has effectively doubled his money (which we know is not likely).

In the days following Eric's purchase, only three hundred additional traders decide to speculate and buy 100 units of $GRWOOF each. This drives the price of $GRWOOF higher, from $1.75 to $3.50. Eric is extremely excited at this point and thinks he's hit the jackpot. However, as we know, despite $GRWOOF trading at $3.50, Eric cannot sell for a significant profit due to the price being propped up by only a handful of bids and asks (current price sellers are willing to sell).

Result

By next week, Eric is trapped because the trading volume of $GRWOOF has declined rapidly. Only the initial traders are still trading it and propping the price of the coin up. The price is still sitting at $3.50. Buyers are holding, and sellers are waiting to see what happens. This is further evidence that no new participants are showing interest in $GRWOOF, which explains the lack of volume.

Eric begins to realize that he cannot sell his five hundred thousand $GRWOOF units because there is insufficient volume AND liquidity. There is not enough bidding volume to match his asking volume. Liquidity risk will become apparent as Eric begins to sell since there are so few buyers at $3.50. Therefore, the perceived $750,000 gain ($1.50 profit from his $2 entry multiplied by the 500,000 units he owns) is invalid.

So, he inevitably starts to sell his $GRWOOF in small batches until no buyers remain due to lowered interest. He might find a few hundred sellers at $3.50 and a thousand or so between $3.00 and $2.00. However, by the time $GRWOOF reached $1.00, he had exhausted most of the buyers and still held an overwhelming amount of $GRWOOF (let's estimate over 60% remaining). He ultimately sells most of his holdings at an average of $0.50 each for a spectacular loss.

The above example shows how easily volume and liquidity risk can occur in microcap trading. The main takeaway is that despite its association with day traders for being risky and lucrative, microcaps are extremely risky due to high volatility in addition to less obvious factors like volume and liquidity. This fundamental understanding is necessary for new traders to be correctly informed and avoid significant losses.

New traders can learn about crypto trading bots or copy trading on the best crypto exchanges from my peers at Coinmonks.

Key Takeaways

• Volume helps to indicate interest in an asset and is a powerful tool for analyzing price action and trends.
• Liquidity refers to how easily an asset can be bought or sold. The higher the liquidity, the easier it is to trade and vice versa.
• Liquidity risk in trading refers to the inability to execute a trade at a certain price due to a lack of liquidity.
• Slippage is the difference between your expected execution price and the actual price. Slippage adds uncertainty to a trading position, so high slippage is viewed negatively.
• Don't be like Eric — stay away from microcaps, as they are extremely risky. However, limit risk and be aware of the asset's slippage if you do decide to trade low-volume and liquidity assets. As a note for crypto trading, you should always use the highest liquidity asset type when executing a trade.
• A bid is the current price buyers are willing to pay, or "bid," for. Bidding is often synonymous with longing or being bullish on a market or asset.
• An ask is the current price buyers are willing to sell, or "ask," for. The asking price can also be referred to as an 'exit' from a trading position.

Thank you for reading!