Liquidity, Price and Leverage
Before moving on to the trade lifecycle, this chapter considers three important aspects connected to trades themselves.
6.1.1 Two types of trading
An apple grower wanting a fixed price for his crop come harvest time enters into a forward trade with an apple wholesaler and receives a guaranteed price from which he can budget for the future. The trade he has agreed will not be re-traded with another counterparty; the apple grower is happy to see the trade through to maturity and collect profit for supplying apples.
A metals trader in an investment bank can see that the future price of lead is lower than should be the case, based on industry fundamentals, and so buys lead futures. He has no intention of waiting for the futures to expire into a delivery of lead - he will sell his futures when he believes the time is right.
6.1.2 What is liquidity?
Whenever a financial entity wants to sell a trade executed with one counterparty on to a new counterparty, there must be a market for that resale to occur. Many trades are conducted with the expectation of being able to re-trade at any time and therefore require markets to be available continuously (or at least during normal trading hours). Others may have fewer potential buyers and sellers.
When a market has an abundance of buyers and sellers, we call it liquid. When there are few, we call it illiquid. Liquid markets have the advantages of:
• competitive prices
• small bid/offer spreads ...