Market Liquidity: Foreign Exchange vs The Stock Market
Is Slippage a Problem?
Let’s face it, every trader on the Planet has wished at some point during their career that slippage did not exist. I for one have cursed at the top of my voice, let alone under my breath, at slippage on an entry or exit. However, every successful trader on the Planet has found a way to deal with it either mentally, technically or most likely with a bit of both. The type of trader you are has a massive bearing on the extent to which slippage can affect you. Investors, long and medium term traders will worry less about slippage because the profit targets involved in this type of trading are generally very large. It is also the case that medium to long term trading often involves entry zones rather than specific entry prices. However, day trading methods, specifically scalping, can be hit hard by slippage, especially if it is excessive. Bearing this in mind it would seem that the logical choice for most day traders would be to choose the more liquid FX market, leaving stocks out in the cold. However, this is not the case. It is possible for stock traders to set a ‘chase factor’ on their entry limit orders. This has the advantage of being able to control slippage. In fact momentum day traders thrive on this order entry system. Coupled with an account with a highly regarded direct access broker and you have the means to be able to enter orders of several thousand shares and control the risk of slippage. Knowing When Not to Trade
Momentum traders are also very adept at picking the times they trade. It is said that knowing when not to trade is just as important, if not more so, than knowing when to trade. Times of poor liquidity, such as lunch times, slow moving markets and pre and post hours trading are often avoided. The concept of picking when you trade is just as important if you trade foreign exchange but not necessarily for the purpose of avoiding slippage. There is no real pre and post hours trading because of the available trading hours with market depth remaining good throughout. It would be naïve to think that slippage plays no part in foreign exchange trading at all. During periods of rapid market movement slippage on market entries and hard stops is commonplace. This activity usually takes place at extremely important data releases such as Nonfarm Payrolls and interest rate announcements. Indeed retail brokers guarantee ‘the price you see is the price you get’ during ‘normal’ market hours but not at times of excessive volatility. Out of Hours Trading
The concept of out of hours trading does not really exist in foreign exchange as it does on say NASDAQ listed shares. During the working week there is always at least one major financial centre open to facilitate trades.
(Table: http://www.passion-trading.com/Articles.marketliquidity.foreignexchangevsthestockmarket.htm) Let us compare this with the NASDAQ. The NASDAQ is restricted to the hours of 09:30-16:30 eastern. Trading outside of these hours is possible but the reduction in liquidity is massive. Price gaps between one day’s close and the next day’s open are commonplace due to this lack of liquidity. If you were to add this to the possibility of company specific and geopolitical news events then huge gaps are possible. At times like this slippage on stop orders can be enormous and gaps can take you past your risk threshold. This is clearly one instant where superior liquidity in the FX market is a massive advantage. Once again it is possible to lessen the effects of these gaps. By using a broker who gives you access to the market out of hours or limiting your exposure to market open hours only you have avoided the problem. It is the case that many forex traders close their positions over the weekend when gaps are possible. This comes down to your trading style as much as anything. If you are a long/ medium term trader then you will have to factor in the risk of gaps. Market-wide Liquidity
Not only is the average daily stock trading volume much lower than in FX but it is also much more diluted. Of the $50 billion changing hands on a daily basis, think how many countries, exchanges and shares this is spread over. Conversely, in the foreign exchange market it is estimated that 85% of the massive $1.8-2 Trillion changing hands everyday is concentrated in only eight major currencies. These currencies can be seen in the table below: USD: U.S. Dollar
EUR: Euro
JPY: Japanese Yen
GBP: Great Britain Pound Sterling
CHF: Swiss Franc
CAD: Canadian Dollar
AUD: Australian Dollar
NZD: New Zealand Dollar
It would be wrong to assume that all stocks have the same levels of liquidity. The fact is that average daily volume and the number of shares outstanding or ‘float’ is the determining factor. If volume is high and there is a large float then executing orders without slippage is more likely. For example, Microsoft (MSFT) currently has an average daily volume of close to 58 000 000 million shares. With this kind of market depth you are far more likely to have an order of 10 000 shares executed without slippage than you are in Sears Holding Corp (SHLD) which has an average daily volume of nearer 2 000 000 shares. Conclusion
So then, if you trade foreign exchange you have the benefits of 24-hour liquidity and market depth. This results in less slippage and potentially more money in your pocket. Case closed then. Or maybe not. The ability to succeed as a trader relies on your ability to adapt and work with the market. Those who choose stocks over forex (and there are a fair few; retail forex has only really been around since the dawn of the internet) are able to deal with liquidity issues and make money regardless. In fact it will seem to these people that liquidity is not even an issue. It is an unavoidable market characteristic that was there before them and will still be there long after they have retired. It is a trader’s responsibility to make the most of the resources on offer to them. So much depends on finding a good broker. Due diligence is vital when making this decision. Two traders executing the same sized order, at the same time, in the same market can experience very different results depending on their brokers. Despite the promise of guaranteed fills it is amazing how many retail forex customers feel aggrieved by the level of service provided them. You need only open your web browser and search for ‘forex broker reviews’ or ‘broker reviews foreign exchange’ to read stories about poor service and order management. Trading profitably is about finding and trading an edge. This edge should make the most of the resources available to you and your characteristics as a trader. It is your goal to work with the market and never against it. The issue of liquidity, or lack of it, is manageable, and manage it you must (there are several pointers at how to do so in this article). Don’t let it be the determining factor in your trading. David Thorpe is a senior contributor for http://www.passion-trading.com a free educational resource centre for traders and investors. The goal of the site is to stimulate the minds of its users, enabling them to achieve a greater understanding the art of trading, thus helping them to become more profitable. |
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