11/08/2010

How to use liquidity cycle to find explosive moves

There is lot of confusion between liquidity and float. Many are confused between liquidity and float. These are two separate issues. A low float stock can have very good liquidity and a gigantic float stock can have very poor liquidity. Liquidity in stocks is cyclical. A low liquidity stock can become very liquid once there is a catalyst. Same way a highly liquid stock can become illiquid if it goes in to neglect phase due to lack of catalyst. Price breakouts followed by liquidity breakouts on stocks with multi month neglect  is a highly profitable strategy.

Let us look at some examples of this. 

Here is a stock which just few weeks ago was a stock which had extremely low liquidity. It often traded less than 1000 shares a day. 



Here is the same stock after a catalyst arrived :



In last 10 days the stock has traded on an average 783000 shares. 

Here is another example of a stock with very few low liquidity few months ago:

This stock traded less than 100000 shares per day till it had a liquidity breakout.


Now this same stock has traded on an average 845000 shares in last 10 days. Which is 8 times more than its average liquidity just few months ago. 

Here is another stock which had below 100000 liquidity just few months ago,

In last 10 days the same stock had average liquidity of 250000.


You can see examples after examples of this if you study stocks up 100% plus in a year. A study like that will show you that liquidity in a stock is cyclical. If a stock is neglected by market it will have very low liquidity and it can continue to be in that low liquidity phase for months or years. Then when something changes either in its business or in external environment it surprises the market by coming out with good earnings or new product news or some game changing catalyst. This results in a explosive move. This is a continuous phenomenon in the market. Unknown and little followed stocks will be the next big winner.

Many traders have never thought through how much liquidity they really need to trade. They set their liquidity requirement in their scans at high enough level that such stocks will not show in their scan. Many traders use average 50 days liquidity in scanning condition. Such condition will never catch a explosive move in a stock which had low liquidity prior to breakout. 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. Look for liquidity breakouts. There is a big edge in such stocks for small speculators. 

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.

If you sort the "Common Stocks" list by volume and look at stock with very low volume you will see many stocks with 100 million plus float but that have no trading volume. Some will trade less than 100 shares in a day. The same stock that has been trading minuscule number of shares per day can quickly become liquid stock if a catalyst like earnings or something appears. There will be "Episodic Pivot" and then liquidity will just explode and persist for months or years.

If you go through all the stocks that make 100% plus move in a year from their 52 week low 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 help you improve your returns, if you can catch start of a new liquidity cycle. Scan to a liquidity break on stock with below average liquidity. 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. There are lot of academic studies that have studied this phenomenon and they show the returns on low liquidity stocks tend to be higher than the returns on high liquidity stocks.

If you want to understand liquidity cycle then understand Stock Turnover Ratio. Stock Turnover Ratio is a measure of 10 day average volume/float. If a stock has higher float turnover ratio it means bigger price swings. Stocks with higher Turnover ratio are in demand. That is why IBD puts that table in the newspaper every Thursday which shows Stock Turnover Ratio. 

IBD will every Thursday publish a small table with stocks with high float turnover ratio.



This table uses Float Turnover to highlight these stocks. If you attend one of the advance courses from IBD, then sometime they talk about this and how they use it to scan stocks in their database.  As a general thumb rule if a stocks float turnover ratio increases significantly, it shows higher demand for stock. That is why NFLX and RVBD are highlighted in that table. But as the fine print says, the Float turnover ratio is not a reliable indicator of future moves. A stock which topped out and is going lower can also have very high float turnover ratio. 


What is  Stock Turnover Ratio or Float Turnover Ratio? 

Stock Turnover Ratio= average 10 day volume/float

Let us take a stock like say JKS. 


It has a float of 10 million. The average volume of  last 10 trading days is 1909520 as per Yahoo finance.

JKS Float Turnover Ratio= 1.9m (avg 10 day volume)/10m float=0.19=19%

What this means is that 19% of the float is turning hands everyday. So there is lot of demand for stock.

Now let us look at float turnover for say QCOM. 




The average 10 day volume is 19.4 million. The float on QCOM is 1573 millions.

QCOM float turnover= 19.4/1571= .03 =3%.

What it means is 3% of float is turnings hands daily. Which shows lower demands for shares. In other words there is 6 times more demand for JKS compared to QCOM. Stocks with high Stock Turnover Ratio are stocks in play or in demand and for active short term trader they offer lot of opportunities on both long and short side. Stock Turnover ratio above 10 is a indicator of good demand. High Stock Turnover Ratio above 30 can help you find very explosive moves. 

Scan for Stock Turnover Ratio if you want to find stocks starting their liquidity cycle or if you want to find stocks in play. The Stock Turnover Ratio is also very helpful for finding shorts. Stocks Turover Ratio will reach a peak prior to tops in market. Excessive Stock Turover Ratio is often a indicator of climax runs in stocks. A high Stock Turnover Ratio with no major price change can also indicate tops or bottoms. 

This kind of analysis is called liquidity cycle analysis. 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.

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. 






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