Understanding Stock Liquidity
When buying or selling shares in a company, most traders want to ensure they are doing so at a fair price.
In many cases novice traders fail to get a fair price because they don't understand stock liquidity and a factor called slippage.
What is slippage? Slippage is the difference between the last trade price and the price realized by the next order.
Typically, slippage occurs when there is a significant imbalance between demand and supply.
For example, if a trader wants to buy 10000 shares of a stock but the average daily volume shares traded for that security is 5000 shares, then there will likely be a great deal of slippage in acquiring the stock.
The act of buying the stock will drive up the share price because there are not enough willing sellers.
One method of preventing slippage is to use limit orders instead of market orders.
But there is a downside to this.
Quite often the stock trader does not acquire the best stocks with limit orders because the price moves up too fast.
Or the trader will get filled on a minuscule number of shares and has to chase the stock by moving up the limit price to acquire more.
Neither of these situations are desirable.
Stock Liquidity When developing a stock trading system, it is good practice to determine the minimum stock liquidity for your needs.
For example, if a stock trader starts with $100K trading capital and plans on holding 20 different securities then he will typically be buying $5K worth of stock at a time.
To avoid major slippage problems the stock trader will likely set certain minimum stock liquidity requirements to filter out low liquidity stocks.
Average Trading Volume Many novice traders will filter out low liquidity stocks by examining the stock average trading volume over the previous 20 days.
20 days is generally not sufficient as a large volume spike on one or two days can skew the average trading volume.
You can end up holding a stock with volume dying off rather quickly.
So it is better to a longer averaging period such as 60 days.
Average Dollar-Volume An issue with examining the average daily trading volume is that it is not necessarily the right factor to monitor.
For example, For example, some stocks on publicly traded exchanges have extremely high valuation, $1000 or more.
The stocks can be quite liquid and one share can easily be bought.
So you can see that trading volume is actually irrelevant.
What is important is average dollar-volume.
In other words, concentrate on the $$$ turned on an average trading day, not the volume of stocks traded.
The minimum stock liquidity for stocks the trader is interested in buying should be based on trading capital and number of stocks held.
For the case mentioned above the trader has $100K trading capital and wants to hold at least twenty stocks.
On average each position will be $100,000 / 20 = $5,000.
When you buy a stock, a good rule of thumb is to buy no more than 1% of the 60 day average daily dollar-volume.
For this trading example, the minimum stock liquidity level should be a minimum $500,000 daily average traded for a particular stock.
Market Capitalization Now the average dollar-volume is fine for acquiring a stock position but what about exiting? When a sell signal comes up the trader will have to sell regardless of the average dollar-volume.
In preparation for selling a stock, consider using market capitalization as a filter before buying the stock.
The idea is that if the market capitalization is too low then stock liquidity is likely a problem, even if the dollar-volume is high.
This provides some buy side filtering for consideration of ultimately selling the stock.
Stock Price The final parameter to consider is the current stock price.
It is a good idea to avoid stocks trading under $3.
There is too much speculation/manipulation for these stocks and they tend to be less liquid.
Conclusion To avoid having excess slippage when entering trades, make sure you consider the stock liquidity (average dollar-volume), market capitalization and stock price.
If you want to trade more than 1% of the stocks average dollar volume then consider breaking the trades into several different orders to manage slippage.
In many cases novice traders fail to get a fair price because they don't understand stock liquidity and a factor called slippage.
What is slippage? Slippage is the difference between the last trade price and the price realized by the next order.
Typically, slippage occurs when there is a significant imbalance between demand and supply.
For example, if a trader wants to buy 10000 shares of a stock but the average daily volume shares traded for that security is 5000 shares, then there will likely be a great deal of slippage in acquiring the stock.
The act of buying the stock will drive up the share price because there are not enough willing sellers.
One method of preventing slippage is to use limit orders instead of market orders.
But there is a downside to this.
Quite often the stock trader does not acquire the best stocks with limit orders because the price moves up too fast.
Or the trader will get filled on a minuscule number of shares and has to chase the stock by moving up the limit price to acquire more.
Neither of these situations are desirable.
Stock Liquidity When developing a stock trading system, it is good practice to determine the minimum stock liquidity for your needs.
For example, if a stock trader starts with $100K trading capital and plans on holding 20 different securities then he will typically be buying $5K worth of stock at a time.
To avoid major slippage problems the stock trader will likely set certain minimum stock liquidity requirements to filter out low liquidity stocks.
Average Trading Volume Many novice traders will filter out low liquidity stocks by examining the stock average trading volume over the previous 20 days.
20 days is generally not sufficient as a large volume spike on one or two days can skew the average trading volume.
You can end up holding a stock with volume dying off rather quickly.
So it is better to a longer averaging period such as 60 days.
Average Dollar-Volume An issue with examining the average daily trading volume is that it is not necessarily the right factor to monitor.
For example, For example, some stocks on publicly traded exchanges have extremely high valuation, $1000 or more.
The stocks can be quite liquid and one share can easily be bought.
So you can see that trading volume is actually irrelevant.
What is important is average dollar-volume.
In other words, concentrate on the $$$ turned on an average trading day, not the volume of stocks traded.
The minimum stock liquidity for stocks the trader is interested in buying should be based on trading capital and number of stocks held.
For the case mentioned above the trader has $100K trading capital and wants to hold at least twenty stocks.
On average each position will be $100,000 / 20 = $5,000.
When you buy a stock, a good rule of thumb is to buy no more than 1% of the 60 day average daily dollar-volume.
For this trading example, the minimum stock liquidity level should be a minimum $500,000 daily average traded for a particular stock.
Market Capitalization Now the average dollar-volume is fine for acquiring a stock position but what about exiting? When a sell signal comes up the trader will have to sell regardless of the average dollar-volume.
In preparation for selling a stock, consider using market capitalization as a filter before buying the stock.
The idea is that if the market capitalization is too low then stock liquidity is likely a problem, even if the dollar-volume is high.
This provides some buy side filtering for consideration of ultimately selling the stock.
Stock Price The final parameter to consider is the current stock price.
It is a good idea to avoid stocks trading under $3.
There is too much speculation/manipulation for these stocks and they tend to be less liquid.
Conclusion To avoid having excess slippage when entering trades, make sure you consider the stock liquidity (average dollar-volume), market capitalization and stock price.
If you want to trade more than 1% of the stocks average dollar volume then consider breaking the trades into several different orders to manage slippage.
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