Trading costs money. You can see this in your securities settlement: Bank charges, fees and taxes arising from order processing - the so-called transaction costs - are clearly shown. Indirect transaction costs incurred by investors due to a lack of trading volume disappear in the fog. Statements such as: "Leave it alone, this share is far too illiquid" often warn against a purchase. But what does that mean?
First, a clarification of the term: Liquidity describes the availability of a security and is expressed in the costs incurred by trading in this security. Liquidity is the liquid that keeps the process of price formation smooth in a market.
As a reminder, share prices are created by the price expectations of buyers and sellers. In a perfect marketplace there is enough supply and demand. Every security order placed is executed immediately, without the individual order moving the price of the security.
"Dry" markets - expensive trading
But in reality the markets do not obey this theoretical construct. And the lack of availability costs investors cash in two ways:
On the one hand, a buy or sell offer shifts the price on an illiquid market to the disadvantage of the investor. This is nothing more than a car seller raising the price of a car because he realizes that the buyer wants exactly this car and that there are no obvious competitors offering the same types.
On the other hand, the order is not executed immediately on an illiquid marketplace. If you want to sell a security for which there is no counteroffer, you can wait until a buyer is found. However, the longer the selling desire remains in the order book, the higher the risk that the price of the security will fall - for example due to changing economic or business-related circumstances. Then sellers can no longer achieve the original price that was valid when the order was placed.
However, if investors want to sell immediately, they run the risk of getting a worse price. The reason: traders who take the security into their portfolio now bear the risks. Do they have all the information that determines the price of the security? Will they get rid of it on this trading day? Or do they have to hold it longer and thus run the risk of a price loss? You will only take the security into your portfolio at a certain discount that covers these risks and costs.
Compared to selling a car, this means that the seller offers his car at the list price, but at this moment nobody wants it. Now the seller can wait and risk a loss of value. Or he sells it to a dealer. The dealer will of course give him a discount on the list price, which depends on his expected chances of reselling.
This discount is expressed in the trading margin on the stock market. The theoretical fair price (the list price for a car) lies in the middle between the buy and sell offer.
The liquidity of a security depends on two factors: The first is the number of securities in circulation (the number of comparable cars of the same type) and the second is the number of market participants willing to buy or sell this security (how many car buyers and dealers there are in a region).
In summary I
The liquidity costs consist of two components, the costs of information risks and the costs of inventory management. These are reflected in the trading margin, 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 larger the available number of shares of a traded security is.
Identify illiquid markets
So how can we judge how liquid a security is? An impression of the available liquidity is of course provided by the ratio, the corresponding volume and the spread between bid and ask. Trading data such as the volume traded, the number of price determinations, etc. are also important indicators. But the trading activity of the past does not necessarily reflect the availability in the future.
An example: If an investor wanted to buy shares of the SDAX value Takkt AG in specialist trading on the Frankfurt Stock Exchange at the beginning of July 2018, supply and demand would certainly have been in the order book. Nevertheless, she would have had to pay 9.89 euros 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 price was 0.9 percent or 9 cents. In a perfect market in which you can sell at any time, the price of the share would have to correspond to the average between the two prices. In our example, the theoretical market value is 9.845 euros. For a round trip (buying and selling the same security) at the same time, the investor would pay 0.9 percent of the invested money. By way of comparison, such a round trip in Commerzbank shares would have cost the investor only 0.08 percent.
With a cash stake of 10,000 euros, the investor would have been charged the same direct transaction fees for both shares. If the shares had been purchased from TAKKT AG, the investor would have paid a liquidity premium and thus implicit fees of EUR 90, but only EUR 8 for Commerzbank. In order to achieve the same gross return on this investment, the investor's technology share has to contribute more.
This simple calculation provides investors with an instrument for estimating the costs of their securities transactions. The higher the turnover in a market, i.e. the more liquid, the lower these costs are.
In summary II
Trading data on the data sheets of the securities provide a good indication of the liquidity of a share: the absolute 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 actual purchase price achieved and the theoretical market value thus reflects the trading costs in markets that are not fully liquid.
However, this difference only captures one dimension of availability. It only considers the breadth of the market. The hidden transaction costs must also include the market depth, i.e. the prices that are set for different transaction volumes. In the case of large orders from institutional investors, demand often exceeds the volume for which prices are quoted. Orders are therefore executed against several limits on the other side of the order book, with the average execution price for the order deteriorating with each execution.
XLM - Measuring cup for liquidity
The Xetra liquidity measure, XLM for short, measures how much costs are incurred due to a 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 expressed in basis points, where 100 basis points correspond to one percent. This allows the hidden liquidity-related transaction costs to be determined for each trading volume.
The most liquid instruments, the Xetra-Most-Liquids, can be called up daily on the basis of the previous trading day via the website. Siemens will lead the list of most liquid instruments in November 2014. A round trip this month would have cost investors 3 basis points (i.e. only 0.03 percent) of the invested amount.
© Juni 2019, Deutsche Börse AG