Did you try the Top-down approach?  Did you see the markets from a different point of view?  Did it make it easier to organize your thoughts about what the markets are doing?  This approach is designed to make your trading experience easier.  I suspect for some it will work well as we described it last week and for some, this approach might take a little tweaking. It is completely fine to tinker with the routines we are throwing out here.  The beauty of being a trader is that no two traders are exactly alike, each trader has a personality and we are trying to develop that here.  The point of these routines is to get you in the mindset of a successful trader.  Successful traders are rule-based traders that have, over time, developed processes into routines incorporating the rules that you learn by both your education and the rules you learn from the marketplace as well.

So, now that we have developed a bias for the markets and the sectors using the Top-down approach we can now go about finding some individual stocks that meet our trading criteria and hopefully concur with our market and sector biases.  One of the ways we can do this by using scanning tools or developing own on watchlists from scans or perhaps just our favorite stocks to trade.  There is a multitude of reasons to pick a stock to trade.  It could be something familiar to you, perhaps a product that you use and understand.  It could be something like our friend at Tackle Trading, Bobby Shannon, who does the environmental hedging blog, he likes to trade stocks of companies that do good things for the planet.  I personally think that is totally cool by the way!  There are a million other reasons to pick a stock to trade.  Some folks just see a good setup and don’t care about the company or ticker symbol at all and that is just fine as well.  Whatever your reason for trading a particular stock is yours and yours alone, however, there is a gauntlet that our stocks must run through to see if those stocks will help us or hurt us and that gauntlet is the rules of liquidity.

Liquidity is a set of rules that a stock must pass if it is to be ultimately tradeable under any of our systems.  Now, I know what you must be thinking, he just told us we could pick any stock we wanted for basically a million reasons, what gives?  I did say that and I meant it.  You can pick any stock you want to start with but if it doesn’t pass the liquidity test then it must be put aside at least for the time being.  I will explain what I mean by that at another time in this blog, just know for now that some stocks will cause you pain and some will put a smile on your face.

Before I get to the rules of liquidity, let me explain why liquidity is so important and what it means if the stock you are trading doesn’t have enough of it.   Let me try to explain liquidity with a game scenario.  Think about playing dodgeball with your friends. If there were only two or three of you playing the game would most likely not be that much fun and moreover, if there was one of your friends that was a stronger dodgeball player he or she would most likely dominate the games and it would make it even less fun.  Now, let’s envision a game where you and all your friends and classmates played in the game.  With alot more people playing the game, it would most likely be more fun and because there are many more targets to hit it would be harder for one person to dominate the game.  This is similar to the liquidity concept, the more people trading a stock the better it is because the stock market works on an auction type system where there are bid prices and ask prices and the spread between the bid and ask gets a lot tighter when you have many people bidding on the same thing and it gets very wide when there are only a few bidders.  This difference, the spread, is like a secondary commission that we have to pay and the bigger that spread is the harder it becomes to make money from the trade because we have to first overcome our costs, which is the commission to trade and the bid-ask spread.  In addition to having lots of people trading to keep the bid-ask tight we also need lots of people to prevent us from getting taken advantage of by someone with a lot of trading capital.

Let’s think about the dodgeball scenario again and let’s say that you have one player that is stronger and faster and throws harder and more accurate than anyone else?  That person could most likely dominate the game and win most of the time.  Now, think about being in a penny stock where there are not a lot of people trading that stock, is it possible for a large dollar trader to come in and buy up most of the shares driving the price up and then dumping it before most of the other traders are aware of whats happening?  Not only is this possible but it literally happens every single day in the markets.  This is the classic pump and dump scenario and it is how a lot of smaller traders who don’t understand liquidity get rooked out of their trading dollars.  So if you think about these two scenarios I think you will be able to understand that a lack of liquidity can be problematic, Yes?

So, how does one protect themselves from harm’s way?  That’s easy, we do what we always do when we are presented with challenges in trading, we follow the rules!  So the rules for liquidity are as follows.

1. Lots of trading volume – by lots we mean ideally over 1 million shares traded on average per day.  If you follow this rule you will save yourself from getting taken advantage of by the big players.

2. We need tight bid-ask spreads.  The more shares that are traded the tighter the bid-ask will be.  Check out the two stocks below, you will see that one has a very tight bid-ask spread and you will see the other one doesn’t and you will most likely recognize the first company name and maybe not recognize the second and there is a good reason for this.

Notice that the bid-ask spread is $0.01 wide on the first one and $0.10 on the second one.  That is ten times as much for the second one and as I said that is a commission we end up paying so I think you can see why the first one would be better, its just simply saving money!  Also, note the differences in the overall volume, one is almost 14 million shares traded and the other is struggling to make 150 thousand.  A hedge fund with enough capital could wreak havoc on the second one but would have a lot of trouble doing that to the first one.

3.  The next thing we look at is the options.  We want to trade only stocks that have weekly options.  The reasoning behind this is that if the stock is traded by enough traders that the exchange will bring out weekly options for the traders to trade and this gives us a real good indication that the stock is tradeable.

4.  Finally, when we are looking at stocks we want to make sure there is liquidity in the options so that we can trade them as well so we need to look at the volume and open interest in the option chain to make sure that we can trade in and out of them.  We ideally want at least 100 contracts of volume and open interest to make sure that we are safe.  The next two images are the same stocks as above but showing their option chains.  Take a look and you will see the difference between liquid and not so liquid.

You can see that there are thousands of contracts available for the weekly options for the first one and the second only has monthly options and no volume in there anyway.  If you were able to get into one of the options in the second example you may never be able to get out because you have to have someone who is willing to buy when you are trying to sell.

So throw your favorite stocks through the liquidity gauntlet and see if they come out unscathed.  If they do then we can put them on a watchlist and look for opportunities to trade them.  If they do not pass the liquidity test then set them aside.

Next time we will go through making a watchlist and using scanners to build good liquid watchlists that we can trade.  Until then make sure you don’t get pummelled by a bunch of dodgeballs!