Liquidity is cyclical | stockbee

4/08/2007

Liquidity is cyclical

dave said...

You have been successfully trading these ideas for around 6 years. How are you able to keep investing in these small stocks as your portfolio has grown? I would be concerned about having a small stock move against me and not being able to unload all of my shares in a timely manner.


The simple answer is by studying liquidity on stocks which I trade.

Many traders have never thought through how much liquidity they really need to trade. That is one of the reason there are profitable opportunities for traders who think through the problem and understand how liquidity changes over a life cycle of a stock.

The day to day liquidity in a stock is cyclical. When a stock with low liquidity has catalyst and get discovered by the market, liquidity comes in within days. If you see the earnings breakouts day in and day out, you will see this phenomenon again and again. A stock will be trading minuscule number of shares per day for long time probably months or years and then earning acceleration happens, suddenly liquidity will surge in and the liquidity will persist for weeks or months or years.

Lets look at a stock below:



It had days when it traded 0 shares in 2002. Now if you go back and see earnings data on this stock, you will notice sales and earnings accelerated dramatically in 2003. What happened the stock broke out during earnings season sometime in 2003. Liquidity increased dramatically and persisted. Now it trades thousands of shares per day. Its float has gone up from 9.5 million in 2003 to 12.6 million, but the daily liquidity has never looked back since its earning lead breakout in 2003.

You will notice that on the following monthly chart for DECK:



I can show you hundreds of examples of stocks which were trading minuscule number of shares per day and then a catalyst like earnings or something will appear. There will be "Episodic Pivot" and then liquidity will just explode and persist for months or years.

Look at WFR, which has currently a float of 223 million and trades millions of share per day. The same stock was a neglected stock in 2001-2202 and had days where it traded less than 10000 shares per day, then 2003 onwards earnings and sales accelerated and boom liquidity jumped and it persisted.



Or look at VDSI which had days where it traded less than 3000 shares a day, then earnings accelerated and kaboom liquidity jumped.




If you go through the 100% plus universe and compare the stocks liquidity 1 or 2 years prior to its 100% plus break, in cases after cases you will see the stock was trading minuscule number of shares per day and when it starts moving up liquidity follows. Price growth brings liquidity.

This happens day in and day out in neglected/virgin stocks. Stocks fall in to markets dustbin, liquidity dries up those stocks get neglected for long periods. A catalyst arrives and boom volume and trading liquidity arrives. If you use a liquidity filter set to very high level, like most traders do, you never catch such breaks.

Many traders have set their liquidity filter at such high level that they don't even look at some of the best opportunities in market. So many people use filter like Average Volume for 90 days should be above 500000. The filter ensures that the best opportunities in the market get eliminated.


The implications are clear for someone who studies this in detail and understand it. It can dramatically improve your returns, if you can catch start of a new liquidity cycle. One of the scan idea under neglect which I have used is to find a liquidity break rather than price break. That often signals start of a enduring long term trend. If you are trading short term strategies or day trading understanding the liquidity cycle can help you design so many strategies. Many successful day trading strategies are based on a very simple understanding of these intra day liquidity cycles.

Understanding liquidity cycles can give you confidence to trade small and neglected stocks. If you want to trade earning breakout, it is extremely critical to understand this, the trade works because previous to the earning surprise there was no liquidity. Once you buy liquidity comes in as several others and funds who understand earnings importance join in immediately. The liquidity will persist post the breakout if in market participants collective judgment that stock has long term potential. Management will add liquidity by releasing more shares through secondaries or insider sells or through stock splits.

Within matter of days a small and risky stock with low volume will become a liquid stock with several thousand shares traded per day.Sometime this will happen within minutes of earnings announcement and it will persist for months. That is how liquidity works in market and that is why I am not scared of trading small stocks with big catalyst or big price increase or 100% growth because I know liquidity follows price growth.

7 comments:

Muddy said...

Again another great post.

I've told folks for years when one scans for stocks breaking out DO NOT use any average volume criteria,if you do you are defeating the purpose of finding the ones that had former low volume that now may begin to be big time trading vehicles.

Regarding 0 volume stocks I've seen it for years (and I'm now into my 43rd year of trading) where they do exactly what Pradeep says.

In fact if one goes here I talk about these 0 volume stocks:

http://greenonthescreen.blogspot.com/index.html
Use the search box for "0 volume stocks"
It is the March 18 post titled Former Zero Volume Stocks

dave said...

Thanks Pradeep for taking the time to give such a thorough answer. When I think of how I could trade some of your ideas, one problem for me would be learning to program excel or some other software to scan for these stocks. Some of your ideas are so compelling though I may have to learn how. Thanks for sharing your ideas and you time.

Dave

Alok said...

Pradeep, in line with what Dave just said, what do you look for in a liquidity breakout. Do you look for a % break of prior days volume or an avg of some number of days vol, or ......

and do you limit your scan to stocks below a certain value or with limited float?

Pradeep Bonde said...

Muddy
Thanks
Yes you are right, the way most people scan for stocks, they eliminate some of the best opportunities.
Most take conventional wisdom about liquidity as gospel truth, that is good, because it creates opportunities for traders like you and me who understand the flaw in the logic.
Dave
Thanks
You can use TC2007 or Stockfetcher and replicate many things. Those two software give you workable solutions, may not be perfect solutions.

Pradeep Bonde said...

Alok
Please see my earlier post:

http://stockbee.blogspot.com/2007/02/float-and-ibds-top-supply-demand.html

The idea is slightly different, it is not for entry timing, it is for selecting stocks which qualify for "Neglect" strategy. The central idea behind that is based on
Norman Fosback's Volume Turover Ratio.

Norman Fosback in his classic book Stock Market Logic provides a
Volume Turnover Ratio to select stocks in portfolio.
Volume Turover Ratio is calculated by dividing total trading volume in a stock over last six months by the total number of shares outstanding. The result is multiplied by 2 to convert it to yearly. Norman Fosback book offers number of detailed studies on effect of stocks floats and supply in general on stock returns.

That is in short the concept behind what I do in one of my "neglect" scan.

pleadership said...

You did not really answer the question? In such illiquid stocks, how do you get out if it trades against you? This is at best a 50-50 business so you must have a rule to ensure your position size does get too big relative average volume. Or not? Maybe 10% of 30 day average volume? In general, I do not think you are trading much money, because otherwise you would have such a risk parameter.

Pradeep Bonde said...

I will answer the question with seperate post later.
Anyone reading this blog for any length of time knows that I am not trading a Goldman Sachs size portfolio.