Low-liquidity markets are often underestimated, but the potential for finding undervalued assets within them attracts investors seeking profits beyond the mainstream. However, these markets also carry significant risks. In this article, we'll talk about the dynamics of low-liquidity markets, examining both the potential rewards and the significant challenges they present for investors. This will help you decide whether or not these markets align with your trading goals.
What is Liquidity and Why does it Matter for Investors?
In trading, liquidity refers to the ease with which you can trade a financial asset (buy it or sell it) without significantly affecting its price. Traders usually face two types of markets: high liquid environments and low liquid environments.
The reasons why liquidity is important for traders and investors is because it can affect their entering and exiting position strategy, as the ease, spreads, slippage, volatility and execution time won’t be the same, depending on the trading activity.
Imagine high liquidity markets as being easier in buying and selling due to their larger trading volume. This results in tighter spreads and potentially lower volatility. Low liquidity markets, on the other hand, present challenges in buying and selling at desired prices and times due to fewer active traders. Spreads widen, and volatility tends to rise in such scenarios.
What Affects Market Liquidity?
● Number of market participants.
● Interest from institutional and professional investors.
● Trading volume.
● Market structure.
● Volatility.
● Media coverage.
● Regulatory policies and requirements.
● Global market sentiment.
● Market depth.
● Market fragmentation.
● Macroeconomic factors.
● Demand
● Other factors specific to individual financial assets.
Hidden Gems: Why Low-Liquidity Markets Can Be a Trader's Paradise
While highly liquid markets offer ease of entry and exit, some investors look to less-traded markets for potential opportunities. Let's explore the reasons why low-liquidity markets might hold appeal for certain investors.
Lower Competition, Undervalued Assets & Potential Higher Returns
Highly liquid markets resemble bustling marketplaces. Everyone has access to the same information, and prices tend to reflect the collective assessment of an asset's value. In contrast, low-liquidity markets operate more like hidden antique shops. Fewer people are actively searching for treasures, and so there's a greater chance of finding something overlooked or mispriced. This lack of competition can often lead to undervalued assets.
Here's where the potential for high returns comes in.
Imagine discovering a hidden gem in low liquidity markets – an undervalued asset whose true value becomes recognized by the broader market after you’ve bought it. This can lead to significant growth compared to established assets in highly liquid markets. By identifying these undervalued assets, investors have the potential to generate “alpha”, which refers to returns exceeding the overall market performance.
Furthermore, developing a deep understanding of a specific low-liquidity market segment can provide investors with a competitive edge.
With fewer participants actively researching these markets, therefore gaining this specific expertise allows you to identify unique opportunities that others might overlook. This niche knowledge empowers you to navigate low-liquidity markets with more confidence, potentially unlocking opportunities that align with your investment goals and risk tolerance.
Murky Waters: Risks of Low-Liquidity Markets
Low-liquidity markets are not for everyone. Traders venturing into these territories should have a high tolerance for risk, as well as specific knowledge to make the most of these markets. Let’s have a look at the most popular risks associated with such a trading environment.
Difficulty Entering and Exiting Positions & Slippage
In high-liquidity markets, executing buying and selling transactions is a breeze. You can typically get in and out of positions quickly, at or near your desired price. Low-liquidity markets present a stark contrast. Here, finding a counterparty willing to take the other side of your trade can be a challenge. This can often lead to prolonged holding periods for your investments, as you might need to wait for someone to match your buy or sell order.
In addition, low-liquidity environments more often trigger slippage than high liquidity markets. This occurs when there aren't enough buyers or sellers at your preferred price point. As a result, your order might not be executed at the exact price you intended.
Imagine you place an order to buy a stock at $10, but due to slippage, it actually executes at $10.20. While slippage can occasionally work in your favor, by getting a better price than expected during a sudden sell-off, these opportunities are not guaranteed and you’re likely to experience negative slippage with low-liquidity markets (an order executed at a worse price than expected).
Larger bid-ask spreads
Liquidity also impacts the bid-ask spread shown in your trading platform. The spread represents the difference between the buying and the selling price for a particular asset. Typically, this difference encompasses the commission charged by your broker for executing your trades and offering your different services (trading platform, research, analytical tools…).
In low-liquidity markets, the bid-ask spread widens significantly, which means that when you buy an asset, you'll likely pay a higher price than the ask price, and when you sell, you'll receive less than the bid price. The wider spread essentially translates to increased costs for each trade. This dynamic reflects the underlying challenge of low-liquidity markets: the reduced availability of counterparties.
With fewer buyers and sellers actively participating in the markets you’re trading, it becomes more difficult to execute transactions at your desired price point (remember what we said about slippage). As a result, investors venturing into these markets should carefully consider the impact of wider bid-ask spreads on their overall trading costs and potential returns.
Higher volatility & Information Asymmetry
Low-liquidity markets are notorious for their heightened volatility, characterized by sharp and sudden price fluctuations. Unlike their highly liquid counterparts, where numerous transactions act as a buffer, even minor changes in buying or selling pressure can have a dramatic impact.
Imagine a single investor placing a large buy order or a sudden sell-off – in a low-liquidity market, these events can trigger significant price spikes or plunges, making it challenging to enter or exit positions at your desired price point or to manage your open positions.
Information asymmetry further complicates matters. These markets often suffer from a scarcity of readily available information. This can be attributed to several factors.
Firstly, with fewer investors interested, there's typically less research and analysis available from financial institutions or specialized media compared to highly liquid markets. For example, smaller companies or penny stocks in a low-liquidity market might not be required to disclose information as frequently or comprehensively as established giants such as Nvidia (NVDA), LVMH (MC), or Rio Tinto (RIO) for instance.
Secondly, obtaining reliable and official economic data can be challenging, especially when dealing with exotic pairs in the Forex market for instance. This makes it difficult for investors to gauge the true health of a country's economy and make informed decisions about buying or selling a particular currency.
The lack of readily available information can lead to situations where even seemingly insignificant news catches investors by surprise, triggering volatile price movements as they scramble to adjust their positions based on the new information.
Success in the Shadows: Tips for Low-Liquidity Trading
● Honestly assess your trader’s profile and risk tolerance to ensure that you're comfortable with the potential losses due to volatility and limited tradability within low-liquidity markets.
● Know how to best take advantage of low-liquidity markets with your selected brokers depending on your trading strategies (allowed trading styles, order types availability with a preference of limit orders and related orders, order book depth accessibility, ability to profit from order book-based execution, ultra-fast and reliable execution, in-depth trade execution reporting …).
● Limit your leverage effect and adopt the right position sizing strategy for your trading capital and strategy.
● Take into consideration that liquidity can vary throughout the trading day.
● Closely monitor economic news releases and other news that can have a significant impact on the assets you’re trading.
● Consider adding assets from low-liquidity markets to strengthen the diversification to your portfolio, potentially reducing overall risk and improving risk-adjusted returns.
● Always stick to your trading plan and risk management rules.
● Exercise patience, as low-liquidity markets often exhibit slower market movements due to fewer transactions occurring compared to highly liquid markets. This can result in fewer trading opportunities over a given period.
● Develop in-depth knowledge of a specific low-liquidity market to get an edge.
The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication.
All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information.
Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk.