One of the most important things to understand about liquidity is that liquidity always and only exists at better prices than the current price.
Seller liquidity exists at higher prices than the current price.
Buyer liquidity exists at lower prices than the current price.
This is common sense because if sellers wanted to sell below market price, then a trade would take place. Buyers would fall over themselves to buy at lower prices than market price because they would be able to turn an immediate profit.
Whilst liquidity only exists at better prices, ORDERS can exist at worse prices.
In this case we are not speaking about liquidity, because it’s not.
For example a breakout trader might have a buy stop order to enter the market above the high. This is an order to enter at a worse price than current but this is going to consume liquidity, not provide it.
There is no seller liquidity below the current inside offer and there is no buyer liquidity above the current inside bid.
This picture makes it clearer:
Some people are PAID to provide liquidity. These people are often called, „Agents“ or “Market Maker”. They „make“ the market although HFTs muddy the water somewhat. Anyone can be a liquidity provider and get paid to place limit orders. Most people don’t as you need deep pockets to play that game. The Market Makers get paid to place these limit orders. As price moves up and down, they are effectively capturing the spread between the inside bid and offer. They do not capture the spread at each price point; no-one can do that. What happens is that the market tends to move back where it came from and the spreads are captured over time.
Market Makers have deep pockets. If a market is roaring up with no retraces, then the Market Maker is going to be short at higher and higher prices; as the price moves down, they’ll unload that position, capturing their rebates and the spread as that occurs. These people aren’t going to remain totally passive if things go too far against them. They can and do play games to ensure they make money. They will push the market around and shake people out whenever the opportunity arises.
These people are not a charity. They are doing it solely for their own benefit. They will stop providing liquidity when it is most needed, which is one of the things that feeds a market crash.
As markets move down rapidly, liquidity providers end up with a large offside long position and they stop providing buy-side liquidity which fuels the move down.
Crashes are not caused by selling; they are caused by lack of buy side liquidity.
Other traders, for whatever reason, will put in limit orders at better prices than current. These may be algorithms or they may be actual people. On the sell side, people can put in limit orders to sell for higher prices. On the buy side people can put in limit orders to buy at lower prices. This is common sense, buyers want to buy low and sellers want to sell high. A trader might have put his limit order in a minute, an hour, a day or a week ago. Various people will have put in limit orders at various times putting in various amounts of thought into the process. If you are day trading, it doesn’t follow that everybody else is day trading. You might see 5000 Bid at a level and think it is somebody trying to turn the market around; this may be the case OR it may be that someone put this order for 5000 contracts in a week ago as a hedge and they aren’t really concerned at all what happens in the next 5 minutes.
“There are ZERO buy limit orders above the current price and there are ZERO sell limit orders below the current price”.
Continued on Liquidity, Part 3