Investing In ETFs: Look At Liquidity


I am always amazed how little investors know about the vital importance of liquidity and its direct co-relation to the risk they are taking on with an investment. In recent years ETFs have gained hugely in popularity. Granted, they have many benefits over trading individual stocks: You do not have to worry about dividends, as there are dividend oriented ETFs trading baskets of high dividend stocks. ETFs typically tend to be less volatile than most stocks, at least the frequently traded ones.

This is obviously due to the fact that you are trading a basket of individual shares rather then one individual stock. If you have an underperforming stock as part of the basket, and the remaining basket performs well, this will cushion you to some extend against news reaction spikes from an individual stock. News spikes are common with individual stocks and can alter the chart pattern of an individual stock in a matter of hours.

The overall trend:

Let’s talk trend for a moment: No, I am not talking about the trend of the markets, rather I am talking about the trend in trading liquidity. This is an entirely different matter and while correlated to market trends to some degree, it is more highly co-related to risk.

The recent major waterfall decline in the market was not caused by some news event, like China’s demise, as is mentioned frequently, no the decline was caused by limit down triggers in the indices across the board sending values spiralling downwards.

If you had been long the DOW, or the NASDAQ or the DAX, to mention just a few, you would have gotten severely burnt, as your stops would have been slipped, in all likelyhood exceeding the risk allocation of your portfolio. This is, incidentally, why I allocate to risk no more than 1% on any position. In the event of this scenario happening you would get burnt, but not hurt to such a degree that you would find it hard to recover from it.

Liquidity is decreasing across the board

The last few years have seen a decrease in liquidity across the board, as institutional trading has been curtailed by regulations. You might despise HFT, but it provides much needed liquidity. The market needs the frequent traders and the big institutions to trade actively to provide liquidity for the smaller guys like your broker, and you and me the independent trader/investor trading their own investment portfolio.

Confidence cycles are turning negative

As if the above weren’t enough of a challenge, we also have to grapple with the effects of a big cycle coming in, a confidence cycle that is turning negative and that will have a massive impact on the market at large: We are already beginning to see the effects of this new long term cycle: There is an increasing distrust in authority. While authorities are doing their best to justify their existence, typiucally stifling free market flow by more regulations, this also is highlighting the chasm that is appearing and which won’t go away in a hurry. Gone are the days where we will blindly follow the dictum of authority.

Most ETFs have poor liquidity

When it comes to trading ETFs, and yes, there are many plus points, you need to choose wisely though, particularly against the backdrop of the bigger picture which is not going to change quickly: Liquidity issues are here to stay and likely get worse and that makes many ETFs very vulnerable.

Right now ETFs are widely promoted as the safe haven against the vagaries in the market. Don’t be fooled by such claims. Many new ETFs are niche products which are simply not suitable for the average investor.

The spreads are very wide, this is always an indication of thin liquidity, and you will see big gaps on the daily charts. Gaps increase risk as they tend to distort the indicators and the chart patterns. Volume of shares traded is important.

Anything under 500 000 shares traded per day is a definite no go area as any larger orders are not likely to be filled right away and thus are susceptible to slippage in volatile markets. You may end up selling, or buying way below/above your price, or not at all if you use limit orders. The latter really could cost you dearly, both physically in Dollar/Euro. Pound terms, and in your psychological capital too.

We are living in times where the universal energies are speeding up

Sudden shifts and changes in direction are going to become more frequent as the universe is resetting itself energetically. Volatility spikes will occur and they will affect the confidence levels of the average investor. We need to feel continuity in order to feel confident in making any decision. This is particularly true for investment decisions. Right now there is much change and little predictable continuity in the conventional sense of the word.

The big game plan is changing from longer term perspectives to more responsive swing trading.

Your trades will last for a few weeks or months, rather than years in the foreseeable future, and that makes it necessary to look carefully at what instruments you are trading. Right now, more than in any time in recent investment history investors need to be nimble and understand the bigger picture beyond the popular, shallow news stories peddled on the likes of CNBC and Bloomberg. They will not tell you what really is going on. You have been told, the rest is up to you.

In the next article I will discuss which ETFs have liquidity and are great to swing  trade, minimizing portfolio risk, rather than increasing it.

Mercedes Van Essen

Mercedes Van Essen

Mercedes Oestermann van Essen has traded since 2001 with extensive experience trading commodities, FX and stocks. She is the author of several books on trading psychology.
Mercedes Van Essen

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