DEFINING LIQUIDITY An Expensive Convenience That Punished Emotion-Based Decision-Making
Liquidity, in any market, can be defined as the extent to which such a market, be it stock, real estate, oil, real estate investment trusts (REITs), mutual funds, exchange-traded funds (ETFs), or gas markets, allows assets to be bought and sold quickly at stable prices. Technically, one thing liquidity does for the society is that it keeps the industry spinning. Despite the myriad myths surrounding its source, impacts, and efficiency, liquidity is real. It is an engineered financial product that serves as a streamlining tool for the process of buying and selling assets in a specific market. convenience for traders, in the sense that they can buy and sell an asset at any time in any proportion or size. If you need some money, as a trader, liquidity may work for you; it may help you lock in some profits in a very dynamic market where money changes hands at the speed of light! Unfortunately, this convenience comes at a price. Here are five reasons why liquidity is more expensive than you think. 1. Swift Transfer of Risks When a trader buys or sells an asset, there is an instant transfer of risk between the buyer and seller. What are the underlying factors behind such a buy? Is it because the companywith the stock is performing optimally? Are its products or services par excellence? And does the stock have a value that’s worth the money spent on buying it? Generally, people buy assets because the liquidity provides a chance for them to do so. But when the value of the asset suddenly drops, 5 ReasonsWhy Liquidity Is Expensive Liquidity provides some measure of
since it was inflated to begin with, the broker and the seller/buyer are protected against the person initiating the trade based on T-plus-3 liquidity. The seller/buyer has up to three days to fulfill the conditions of the transaction. If you are selling, you must make sure the buyer gets the asset and the broker’s fees are paid within three days. 2. Brokers’ Paradise Investors are drawn into the market by liquidity, but their demand to be able to get their money out is misplaced, at least for some (large) percentage of their portfolio. Surprisingly, the liquidity favors brokers. The larger the number of participants in the market, the higher the amount of fees they can collect from traders’ activities. Whose paradise does liquidity create? Brokers’ paradise, of course. 3. Volatility A highly liquid market is prone to uncontrollable volatility. And the commission structure facilitates volatility, meaning your broker gets paid when you sell. In other words, liquidity is not built for traders to actualize their financial liberty, but it is made to worship and sacrifice their sweat on the liquidity altar. 4. Anti-Inflationary Inflation hurts liquid assets. When there is inflation, they become a little more expensive than they used to be. Since most countries, including the U.S., have inflationary issues, it is right to say that liquid assets are unstable, unpredictable, and a disaster waiting to happen. abnormal. The amount of greed, carelessness and thoughtlessness, exposure to dangerous risk, and speculation displayed by traders often drives the market crazy — sometimes to a breaking point. Liquid markets crash every now and then, and theywill continue to follow the same pattern because of unmanageable volatility and unsustainable risk level in the liquid market. Liquidity’s Dilemma Here is a perennial dilemma: Liquidity only works when capital demands are idiosyncratic, meaning when market participants have different needs, it creates a complex and robust financial ecosystem. 5. Liquid Markets Are Crashing Liquid markets are usually volatile and
If we all have the same needs in the same time horizon, correlations go to one. This means returns for the individual are the same as the whole market. In reality, all assets require both a buyer and a seller to become liquid. If we all buy or sell at the same time, there wouldn’t be any liquidity. And if we, so to say, are desirous of the same thing at the same time, a competition will be created. This may increase the cost of executing trades or even cause a sudden crash in the market. What traders give up when they embrace liquidity is transparency and the possibility of trading in a less-chaotic and normal market, if there’s anything like a normal market. Emotion-Based Decisions: HowLiquidity Punishes Traders Markets are dynamic, and traders are compelled to live with volatility, no matter how scary and sometimes counterproductive it may be. The unpredictability in the market often makes traders vacillate between fear and complacency. When trading, everyone has a stop, a point when the value of the asset (e.g., stock) gets so low that they have to sell. Not everyone has the stop in mind — in fact, most people don’t — but everyone has it in their body. However, people can derive confidence from feedback loops, watching other people, or receiving recognition from fellow traders. Liquidity creates an atmosphere where greed and self-interest underlies it all. Traders, more often than not, are caught making adrenaline- fueled decisions or trade moves. When they are on the other side of the trend, when the liquidity is pushing the trade against them, some traders end up being punished severely by liquidity. They may lose a chunk of their portfolios in addition to paying humongous brokers’ fees. When buying or selling an asset, a liquidity trader may overlook the necessary steps in safe trading, such as paying undivided to analyses (technical or fundamental) and maintaining a steadfast trading psychology. Liquidity is a cruel punisher of thoughtless traders who do not do their homework before jumping into the markets. They may lose part — or all — of their trading capital.
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