Newsletter: Liquidity and the MOVE Index - An Early Warning Signal of Financial Crisis

Liquidity has been in the media a lot lately. It’s one of those things we take for granted, until it’s dried up. In Fractal Market Analysis (1994) I made the point that markets don’t exist to give you a fair price (an assumption of the Efficient Market Hypothesis). Markets exist simply to supply a mechanism for trading, and trading requires liquidity. That’s why the Fractal Market Hypothesis (FMH) is about trading and liquidity in the end. When trading horizons shorten overall, information becomes interpreted in a uniform way. In low uncertainty times, the market doesn't react as a unit to economic announcements as they do now. Traders diversify one another. But in high uncertainty news puts the trading volume on one side:

1) Good news means a lot of buyers, and

2) Bad news means a lot of sellers.

If we think of trading volume as supply, this type of volatility isn’t due to lack of supply, but an imbalance in demand/buyers and supply/sellers. I call the balance of buying and selling “trading liquidity.” Lack of trading liquidity leads to volatility. It can also be a sign of an impending market and financial crisis.

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