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Liquidity as a cost factor

What impact trading volume can have on returns 
Welchen Einfluss das Handelsvolumen auf die Rendite haben kann
Trading costs money. You can see this on your securities statement: Bank fees, charges and taxes resulting from order processing are clearly shown - the so-called transaction costs. Indirect transaction costs that occur due to little trading volumes disappear in the fog. Statements such as: "Don't touch it, this stock is far too illiquid", try to warn. But what does that mean?

First, a clarification of terms: liquidity describes the availability of a security and is expressed in costs arising from trading in this security. Figuratively described, liquidity is the liquid that keeps the process of pricing smooth in a market.

As a reminder: Share prices are determined by the price expectations of buyers and sellers. On a perfect market place there is enough supply and demand. Each securities order placed is executed immediately without the individual order moving the price of the security.

"Dry" markets – expensive trading

But in reality, markets do not obey this theoretical construct. And the lack of availability costs investors cash in two ways:

First, a buy or sell offer shifts the price on an illiquid market to the disadvantage of the investor. This is nothing other than a car salesman raising the price of a car because he notices that the buyer wants exactly this car and that no competitors offer the same types in recognizable proximity. 

Secondly, the order is not executed immediately on an illiquid marketplace. If you want to sell a security without a counter offer, you need to wait until a buyer is in the marketAnd the longer your limit is in the order book, the higher the risk that the price might fall - due to changing economic data or news from the company.  

However, if investors want to sell immediately, they take the risk of getting a worse price. The reason: traders who take the security into their portfolios now bear the risks. Do they have all the information that determines the price of the security in question? Will they get rid of it that trading day? Or do they have to hold it longer and thus take the risk of a price loss? They will only hold the security at a certain discount covering these risks and costs. 

Compared to selling a car, this means that the seller offers his car at list price, but at this moment nobody wants it. Now the seller can wait and risks a loss of value. Or he's selling it to a merchant. The latter will of course give him a discount on the list price, depending on his expected chances of resale. 

This discount is reflected in the spread between bid and ask. The theoretical fair price (the list price for a car) lies in the middle between the offer to buy and the offer to sell. 

The liquidity of a security depends on two factors: the number of securities in circulation (the number of comparable cars of the same type) and the number of market participants willing to buy or sell this security (i.e. how many car buyers and dealers occur in a region).

Summarized I
  • Liquidity costs consist of two components, the costs of information risks and costs of holding securities. These are reflected in the spread, which is published in the form of bid and ask quotes.
  • A market is all the more liquid the more buyers and sellers are active there and the greater the number of shares available in a traded security. 
Recognizing illiquid markets

So how can you assess how liquid a security is? An impression of the liquidity is naturally provided by the bid / ask quote, the spread between bid and ask and the corresponding volume. Trading data such as traded volume, number of price determinations, etc. provide another important reference point. However, past trading activity does not necessarily reflect future availability. 

An example: If an investor wanted to buy shares of SDAX stock Takkt AG in specialist trading on the Frankfurt Stock Exchange at the beginning of July 2018, then supply and demand would certainly have been in the order book. Nevertheless, he would have had to pay € 9.89 per share. Whoever wanted to sell on the same date would have received € 9.80 euros for the share. The difference between the bid and ask prices was 0.9 percent or 9 cents. In a perfect market where it is possible to sell at any time, the price of the stock should be the midpoint between the two prices. In our example, the theoretical market value is € 9.845 euros. For a round trip (purchase and sale of the same security) at the same time, the investor would pay 0.9 percent of the invested money. In comparison, such a round trip in Commerzbank shares would have cost the investor only 0.08 percent. 

With an investment of € 10,000, the investor would have incurred the same direct transaction fees for both shares. For the TAKKT shareshe would have paid a liquidity premium and thus implicit fees of  90, but only € for Commerzbank shares. In order to achieve the same gross return on this investment, the investor's technology share must bring in correspondingly more.

This simple calculation provides an instrument to estimate the costs of their securities transactions. The higher the turnover in a market, i.e. the more liquid, the lower the costs. 

Summarized II
  • Trading data on the securities' data sheets provide a good indication of a share's liquidity: the order book turnover, the number of price determinations, but also the size of the spread and, of course, the open Xetra order book. 
Market breadth and depth count

The difference between the real purchase price and the theoretical market value reflects the trading costs in markets that are not fully liquid.

But this difference only covers one dimension of availability. It only looks at the breadth of the market. The hidden transaction costs must also take into account the depth of the market, i.e. the prices charged for different transaction volumes. For large orders from institutional investors, demand often exceeds the corresponding volume. Orders are therefore executed against several limits on the other side of the order book, whereby the average execution price for the order deteriorates with each execution. 

XLM measuring cup for liquidity

The Xetra liquidity measure, XLM for short, displays the costs due to lack of availability. It determines liquidity on the basis of the different bid and ask prices for different transaction volumes. Since 2002, the XLM has been recorded for all securities traded on Xetra and is shown in basis points, whereby 100 basis points correspond to one percent. The hidden, liquidity related transaction costs for each trading volume can thus be determined.

The most liquid instruments on Xetra can be called up daily on the Internet site on the basis of the previous trading day. Siemens leads the list of most liquids in July 2018. A round trip would have cost investors 3 basis points (i.e. only 0.03 percent) of the amount invested.

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