One of the most important rules we have here at PATs is to make sure that you trade only liquid markets. There is great dander in day trading thin (low volume) markets, and this article is going to explain the danger of day trading low volume markets – even with price action strategies. You see, prices can rise and fall rapidly in low volume markets and there is so much danger of slippage that even if you are able to enter at your desired price, the odds of you exiting at your expected price is slim to none, particularly if you are trading large volumes. These rules hold true no matter what type of market you are trading, including with stocks, futures and Forex.
Based on this rule, we must always ensure that our trading market of choice has sufficient volume to ensure that we are able to enter and exit at our desired prices. If we plan to scalp, it’s even more important, because even a single tick or pip of slippage when scalping can make or break our profits. We found a great article by Erik Kobayashi-Solomon that was posted at www.news.morningstar.com that explains exactly what can and will happen when you trade illiquid markets. Here is that Erik had to say in his article.
Early in my career, I met a man who was running a small “micro-cap, value-stock” hedge fund that was doing well, both in terms of returns and in assets under management. I was looking to get into the hedge fund world at that time, so I invited him out for dinner to learn more about his fund and hopefully land a job.
After a few drinks and some good food, the manager (who shall remain nameless) confided in me the secret to his investment success: “I invest only in global micro-cap firms that hold a lot of cash on the balance sheet.” He then proudly told me about a great investment he had found in Indonesia–a rubber plantation that held the equivalent of $0.40 of every dollar on the balance sheet in cash (the remaining $0.60 was the land occupied by the farm). The company was trading as a penny stock on the Jakarta exchange. He had been buying it for the last six months and had enjoyed terrific returns on the investment so far.
While that might sound like a sensible strategy (and he certainly had plenty of clients), my interest in working for him lasted only as long as the dessert course. Why? As he was explaining his rubber plantation investment, I soon realized that his returns were only thanks to a thin market and the animal spirits of people who didn’t know any better.
This manager would find a “great” company–under his definition of “great”–and would start buying it. In order to build his position, he would just start hitting the “ask” price. When he did so, whoever else was holding the stock saw his trade go through and decided to offer their shares at a price higher than the previous trade. When this trade went through as well, someone else decided to offer his shares at an even higher price. After a few days or weeks of this, the price of the shares of the target company had risen substantially, just because sellers understood there was someone willing to pay any price to buy the shares.
If the manager were the only one bidding for the shares, he would not be able to show unrealized profits–his action was driving the price up, so his average purchase price would be the average price of the shares over that period. However, the manager was operating in a market, not a vacuum, and in a market, other people see the price action of stocks and make decisions based upon that action–this process is called “herding.” So investors saw the price of the stock go up and up and up, and thought “Wow! Somebody must know something! I’d better buy this stock!” And they would go ahead and hit the ask price for the stock, and the price would go up even more than if the micro-cap manager were in the market alone.
This is a perfect example of what people term a “crowded trade.” The market price of the asset–which usually gives an indication of the instantaneous worth of one’s position–is not a very good measure of wealth in cases like this. This is because the market price shows the last price paid for the asset in question, and not necessarily the price at which the asset can be sold if you want to take profits. What the manager had done was to basically create an extremely illiquid money market mutual fund and charge clients 2% of AUM and 20% of unrealized profits to do so! You can read the rest of the original article here.
As you can see from this interesting story, what looked like a great trader and fund manager on the surface, was nothing more than an illusion that was created by trading a market that was so thin that the traders own buying was driving prices higher, and when it came time to sell, his own selling drove the market down even faster.
This is one of the main reasons we love day trading the ES or Mini S&P. The ES is one of the most liquid markets in the world, and it’s very unusual to get even a single tick of slippage when day trading the ES during regular trading hours. Extended hours trading is another story, but when trading the regular trading hours, I have rarely ever gotten any slippage at all. This makes the ES a great market to day trade and scalp with our price action trading strategies. If you plan to become a day trader, be sure that you understand the danger of day trading low volume markets – even with price action trading strategies. Learn more about how we use price action trading by going to http://priceactiontradingsystem.com/pats-price-action-trading-manual/.