Study: Trading Volumes and Liquidity
By Jan Dennis
Playing a hunch is as ingrained in financial markets as short selling, margin buying and the opening bell.
But a new study by a University of Illinois professor shows that gut feelings don't necessarily pay off when it comes to deciding the best time to trade.
Finance professor Timothy C. Johnson tested a widely embraced notion that volume equals liquidity in stock and bond markets – in short, that heavy trading makes it easier for people to get in or out of markets quickly with minimal costs or losses.
His findings, based on a review of government bond market transactions from the mid-1990s and stock market reports dating back to 1927, counter what Johnson calls an "intuitive feel" that high volume and liquidity should go hand in hand.
"We certainly feel that way in the real estate market," he said. "People feel that if there's a lot of people buying and selling houses, then it's probably easier for them to buy or sell quicker in an active market."
But, heavy volume in financial markets can just as easily put liquidity at risk, netting wide price fluctuations as sometimes small blocks of traders motivated by greed or fear fuel buy offs and sell offs, according to the study, "Volume, Liquidity and Liquidity Risk," published in the February issue of the Journal of Financial Economics.
"High volume is people piling in or out, while liquidity is provided by people who are staying in the market with no reason to leave," Johnson said. "Those core investors ultimately determine how easy it is to get in or out. How willing are they to accommodate other people's trades? There can either be great willingness or not very great willingness."
While heavy volume can bring steep price swings that threaten liquidity, light trading doesn't necessarily signal the best time to buy or sell quickly and easily, he said.
"You can't say that low-volume markets are better," said Johnson, a former hedge fund trader. "What is true in low-volume markets is that liquidity is more predictable and price swings are less dramatic."
The paper is the third on volume and liquidity written by Johnson, who is working with the Chicago Mercantile Exchange on a real-time index that traders could use to gauge liquidity.
He hopes his latest study helps focus efforts to accurately measure liquidity. Many past academic studies have promoted a link between liquidity and volume, which he says is "probably a dangerous thing to do."
"I would say the main message from an investor's point of view is that high-volume markets can signal a great deal of liquidity risk and they're not necessarily markets where it's easy to transact. They're somewhat treacherous markets," he said.
Johnson says his research also could help shed light on market conditions, in general.
"High-volume markets are usually thought of as healthy markets, that things are functioning well if volume is high and that something must be wrong if volumes are low," he said. "That's not necessarily true and I'm pointing out that high-volume markets can sometimes be masking changes in market conditions that would seem quite dangerous, when liquidity is actually drying up."
Tim Johnson - Faculty Profile
(Story and photo courtesy of UIUC News Bureau)