The Market Has A Liquidity Problem (For Now…)
Trading was unusually light last week and likely be light this week. In fact, there’s not enough liquidity for me to recommend a trade in one of my premium services, which is unusual. In fact, this is the first time I haven’t had enough confidence in the market’s liquidity to recommend a trade.
Let me explain why this matters…
Liquidity Is Good For Markets
Liquidity describes how easily a trade can be completed. For example, when we sell a put, we need someone to buy that contract in order to complete the trade.
This doesn’t mean we need someone who expects the stock to decline. Although buying puts is one way to benefit from an expected decline, there are other reasons traders buy the puts that we sell.
The most common reason there is a market for our trades is high-frequency trading (HFT), which now accounts for more than half of all trades.
Many individual investors believe HFT firms take advantage of them. In my opinion, HFT firms are among the most positive developments for individual investors since commissions were deregulated in 1975.
When we place an order to sell, our broker sends the order to the market. The market is no longer a group of men standing around the floor of the exchange like it was 50 years ago. Now, the exchange is a collection of computers.
The order displays on a computer, and HFT firms compete to fill the order. The firms execute trades with high-speed computers and algorithms that allow the firms to profit from trades priced in fractions of a penny.
Many of the algorithms use a formula to define the relationship between the three products an investor could buy – the stock, a put, and a call. The correct value of a stock in relation to its options is defined by the put-call parity equation. The simple version of the formula says that the value of a put plus a share of the stock is equal to the value of a call and the present value of the option strike price.
P + S = C + PV(A)
P = price of put with strike price A
S = price of stock
C = price of call with strike price A
PV(A) = net present value of the option’s strike price
Basically, it says the value of a put and the stock is equal to a call and some cash.
When we enter an order to sell a put, the firm needs to balance that equation to make a small profit. They do this thousands of times a day and it can be quite profitable. Most importantly, from my perspective, they allow us to execute trade.
It means we can be sure we are getting fair prices for the options we trade. If we were not getting fair prices, arbitrage traders would jump into the market and push the mispriced option back in line with the put-call parity equation.
Arbitrage Traders Step In…
Arbitrage traders look for assets that are equivalent to each other but are traded in different markets. If one market is mispricing the asset, the arbitrage trader can make a risk-free profit by buying in the cheaper market and selling in the more expensive market. For Wall Street firms, this is easier than it sounds.
Years ago, the classic example of arbitrage focused on New York and Chicago. Futures on the S&P 500 were traded in Chicago while the individual stocks in the index traded in New York.
If futures prices deviated from the value of the 500 stocks, arbitrage traders would buy the market that was underpriced and sell the overpriced market. They would then reverse the trade with stocks and futures priced at the correct value. The result was a riskless and guaranteed profit.
This trade required access to real-time market data, large amounts of trading capital to buy and sell 500 stocks at a time, and high-speed computers to spot the trading opportunities. Only the largest firms could compete at first, but eventually other firms found a way to take part in arbitrage trading. Those other firms are the HFT firms that allow us to trade.
Action To Take
To be honest, the type of trading we typically do would not have been so consistently profitable even in the early 2000s. That’s because our trades would’ve depended on the ability of the men — and a few women by that time — on the exchange floor to balance our orders so they could be filled.
But there are times when the liquidity just isn’t there. Generally, these periods are restricted to a few hours or a few days at a time. Last week, with the holiday-shortened schedule, volume is low and the puts I had signals in are not trading. I don’t believe there is enough liquidity that we could get into the trade at a fair price, and overpaying to open a trade is one of the quickest ways to lose money.
If you’re trading on a regular basis, hopefully this can be an illustrative lesson for you. Sometimes you just need to back away and let the market come to you. Either way, I’m certain this is temporary and expect it to be resolved by next week. By then, traders will be back from holiday breaks and go back to providing liquidity for end-of-year portfolio rebalancing.
P.S. Regardless of what happens in the market in 2021, I have a plan to ensure that we get paid either way…
I like to think of it as an “insurance” plan — because it allows us to get paid instantly, rather than sit around and wait. My subscribers and I have been trading this way for years, allowing us to pocket hundreds (or even thousands) of dollars with very little effort.
I think every investor who’s looking for income owes it to themselves to learn more about how this works.
That’s why I just released a brand new report that gives you all the details. You can access it right here.