Liquidity is the condition by which an asset can be readily exchanged for cash without a big impact on its market price. An asset is highly liquid if it can be sold for its intrinsic value.
Cash is liquid, it can be exchanged at face value. Assets such as real property, artworks, and collectibles are less liquid. Other instruments such as equity and such investments, can have relatively different liquidity levels, depending on the situation.
In a market, liquidity also depends on the level of trading activity. The more an asset is traded, the higher its liquidity. A lower volume of trades means it is relatively illiquid. Liquidity plays a big part in ensuring an asset can be sold or exchanged for a value that is not exceedingly lower than its market price.
While liquidity across many assets remains high in developed markets, many emerging markets suffer from significantly low levels of trading venue liquidity, effectively placing a constraint on economic and market development.
Technology-driven trading can possibly help increase liquidity in these markets, since it increases trading volume and frequency, driving movement of the asset, reducing trading costs, and providing the ability to move easily in and out of the asset.
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A liquid market is generally associated with lower risk and can attract more traders to participate in the exchange. While cash is the most liquid asset, other instruments are easily fungible or converted to cash, such as cryptocurrencies and other cash-like instruments.
Some examples of instruments and the factors affecting their liquidity:
- Bonds’ liquidity usually hinges on the risk that the bond issuer won’t actually repay the money. The less liquid the bond, the higher the commission you’ll have to pay to sell it, which has the effect of lowering your price.
- As for commodities, gold has the highest trading activity among all precious metals and is, therefore, the most liquid. Crude oil, on the other hand, is the most traded energy commodity, but its liquidity is negatively affected by the current global situation.
- Cryptocurrencies are increasingly liquid because of the growing number of exchanges and markets. This leads to an increased volume in trading resulting in liquidity, which means traders can trade easily, quickly, and at fair prices.
Trading strategies to ensure liquidity
There are different trading strategies to leverage in growing one’s portfolio but not everything has access to liquidity. A long-term investment such as stocks and bonds can be a good way to grow in the long-term, but traders won’t be able to easily liquidate or convert these immediately to cash if needed.
Meanwhile, other strategies such as algorithmic and high-frequency trading can enhance liquidity for both the trader and the market.
“There are general terms for investments, such as ‘high risk, high returns’, and ‘low risk, low returns’,” says Andre Gerald, Chief Executive Officer of Prance Gold Holdings, a technology platform that uses algorithmic trading to grow cryptocurrency and other asset holdings. “We need to change the mindset in trading and establish a platform where everyone can enjoy the lucrative returns with minimal risks involved.”
Maximising asset growth through technology and high-frequency trading
Algorithmic trading takes advantage of a predetermined statistics-based strategy that can run 24/7 with minimal oversight. “By reducing the frictions and costs of trading, algorithmic trading can potentially enable more efficient risk sharing, facilitate hedging, improve liquidity, and make prices more efficient,” according to a study published in the Journal of Finance.
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The main philosophies behind most algorithmic trading revolve around using software to spot profitable opportunities and jump on them faster than a human could.
As there are many opportunities that arise quickly, algorithmic trading takes advantage of that. It automatically initiates the trade so traders can grow their assets without the risk of the trade costing more than the earnings.
High-frequency trading is a subset of algorithmic trading that involves transactions done at high speeds, with a huge turnover rate, co-location, and high order-to-order ratios. While this is a viable strategy, there are certain factors affecting its profitability. “Speed is the most critical success factor where all trades need to be successfully completed to ensure profitability within seconds,” Gerald says.
With high-frequency trading, traders can take advantage of any opportunity by using automated trading platforms to analyze the markets and spot emerging trends within a fraction of a second. It allows traders to get returns in a short period of time to grow their portfolio and at the same time increase market liquidity.
Increasing liquidity through high-frequency trading
Learning the right strategies will help in maximizing both the asset and portfolio. The advantage of being liquid is that a trader is not locked to a particular asset or asset class in the long term, enabling more profitable trades once the opportunities come to light.
Automated and high-frequency trading can drive volume and will thus improve liquidity in both one’s portfolio and the market in general.
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