A conservative trader shouldn't touch any stock outside the derivative sector until settlement. A correction could trap him badly
High liquidity and lots of depth are desirable attributes for stockmarkets. Liquidity and depth are easily understood intuitively but difficult to objectively quantify. A liquid share is traded continuously in large quantities. The depth is good if volume remains ample even on a big price swing.
But what is a “large” transaction? There is no single objective answer. The float (the percent of outstanding equity held by the general public) varies as does the total equity outstanding. Churn (percent of equity traded) also varies. The shares delivered (as opposed to settled) also varies. Liquidity can only be defined relative to these variables.
Nor is there a single objective answer for depth. Say, a stock trades Rs 10 lakh at Rs 100/ share. If similar volumes occur at Rs 95 and Rs 105, it has good depth on a 5 per cent swing. Very often, depth is asymmetrical. Volumes may rise as prices uptrend. If there’s a daily circuit filter, depth and liquidity can also be affected.
One way to get a handle is via an understanding of impact cost. The impact cost is the variation in prices caused by a transaction. Given enough data, impact cost is quantifiable. Look at the smallest bid-ask spread. Say, a seller is offering to sell 1,000 shares at Rs 100 and a buyer bids to buy 1500 shares at Rs 99. The bid-ask spread is Rs 1 and the average price is 99.50 is considered ideal.
If you wished to sell up to 1,500 shares, you could match the Rs 99 bid and you could buy 1000 shares at Rs 100 without problems. In either transaction, your impact cost would be Rs 0.5 because it is that distance from the ideal price Rs 99.5.
Now, suppose you buy 2,000 shares. You get the first 1,000 at Rs 100 but you the second 1,000 costs Rs 102. Thus, the averaged price is Rs 101. This is Rs 1.5 more than the ideal. The impact cost has been 1.51 per cent.
Obviously impact cost is dependent on the transaction size relative to liquidity and depth. The lower the impact cost for a given size of transaction, the more liquid the share.
Also, a low impact share is likely to have better depth. The NSE uses Rs 50 lakh as a cut off transaction size, when it comes to Nifty stocks. It reckons a Nifty stock will not see more than a 1.5 per cent impact cost on a Rs 50 lakh transaction.
If a share has high liquidity, good depth and low impact costs, it enhances the confidence of traders, investors and lenders. The USP of a stock market listing is that it offers continuous entry and exit options. That gives traders the confidence to bet big. A promoter with highly liquid listed shares can also more easily pledge equity at need to raise loans.
Impact cost, liquidity and depth are all variables that change rapidly. Overall market trading volumes in India can double or triple during bullish phases and individual shares often see much higher multipliers. This is similar to patterns in other markets with decent trading mechanism.
When we’re dealing with the broad market, the concept of depth is often associated with the related concept of breadth. Many companies, especially small caps, develop liquidity only during bullish phases. They may be traded much more infrequently or not at all during bear markets.
Daily trading volumes have risen by around 40-50 per cent in the past month. That’s consistent with the market’s bullish trend. Breadth has risen. Impact costs have also dropped – again, consistent.
A look at recent trading volumes suggest that there would be fair depth all the way down to Nifty 5,000. However, volumes would drop if there was a correction below 5,850 and more importantly, breadth would narrow with every 100-point fall.
The potential loss of breadth represents an insidious danger that most traders don’t cater to. It’s one thing to be braced for a fall and to keep stop-losses. It is another thing entirely to be unable to exit a position because the share ceases to be traded actively.
This is especially relevant during a settlement week when the focus is on derivative stocks and we see a trend of higher volumes allied to narrowing breadth. The conservative trader shouldn’t touch any stock outside the derivative sector until settlement. If a correction occurs in the next four sessions, he could be badly trapped.
