A Story of Liquidity, Volatility, and Returns

  1. Block trades — Block trades are large blocks of an asset which are negotiated directly between one party and another party. Most block trades occur between institutions (hedge funds, banks, etc.) and are over-the-counter so you never actually see them. In a block trade, the two parties arrange privately a price to sell/buy which is usually at a discount to the market price. This allows the order to stay private, which otherwise might severely impact market price. These are not reported by default to the tape (Consolidated Tape System).
  2. Dark pool — Dark pools aren’t a sinister word. They’re effectively closed off markets (kind of like a VPN) that are managed privately that don’t give info for participants about the market depth, so HFT algos and the like can’t prey on customers. They can also be completely intra-company and are often used by market makers at big institutions to fill orders. The orders unlike block trades do end up on the tape, but usually not immediately. DIX is a famous indicator that looks at buying/selling pressure in dark pools.

Liquidity and Volatility

So you might be asking — why do I care about this? First off, you’re the one reading a trading blog post, not me. Nerd. Secondly, liquidity is important for even retail to understand for two reasons — volatility (how much the price of the asset moves) and returns (how much money you will make/lose).

Liquidity and Returns

An especially adept reader will point out to me on twitter the following graph, or some variation thereof:

Credit: Euan Sinclair
  • In times of low trading volume, fortune (and statistics) favor bullish movements
  • In times of high trading volume, best run for cover (selloffs)
Credit: J.P. Morgan QDS (Borrowed from Zero Hedge, shamefully)
  • If I try to sell the asset for more — another seller could come in and undercut me, selling it at the prevailing market price.
  • If I try to buy the asset for more — I will be allowed to (sure, it’s free money for the seller), but if I then try to sell it again, the first point applies.
Credit: Campbell B. Harvey

Conclusions

In summary, there’s a time-tested relationship between volatility, liquidity, and stock returns. It’s important as a trader to be mindful of the relationship, and understand it no matter what system you use (crayons, order flow, or indicator nonsense). In my next post I’ll go into capitalizing on it with various strategies (dispersion, selling premium and the VRP, and structural illiquidity and delta hedging). Cheers.

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