Avoid the Liquidity Trap

October 13, 2015, 13:00 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

With the poor market performance this year and the renewed reality, one that should not have went away, that market risks are real and demand for assets as a result of stimulus may indeed have caused an asset bubble, some investors are now opting for trading strategies.

Unfortunately, when investors become traders they often make very discernible mistakes.  Using three equities that have been exceptional trading vehicles recently I will explain one of those pitfalls and more importantly explain how to avoid it.

The three equities we will discuss our Twitter Inc (NYSE:TWTR), Lumber Liquidators Holdings Inc (NYSE:LL), and ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO).

Before I begin I will touch on the news for each of these because almost everyone will rationalize recent moves with corresponding news, but in my opinion, especially for trading purposes, news is much less important than price:

• Twitter:  the company has recently revamped its advertising model and higher advertising revenue rates are expected, but the company has also decided to lay off 8% of its work force.
• Lumber Liquidators: the company has recently settled a legal issue with the department of justice but class action lawsuits, a possible CPSC recall, and possible fines as that relates to California's Carb2 emissions violations are still possible.
• UCO:  this is the double ETF for oil and oil has had a great month, but it has had a horrible year as well.  OPEC is taking aim at global production and especially drillers who cannot afford to survive with oil prices this low.  Importantly, most OPEC nations can't either.

Each of these three names has been up and down about 10% over the past couple of weeks.  They have increased, fallen back, increased again, and arguably have been exceptional trading vehicles if you have been on the right side of the fence.  Lumber Liquidators had the most pronounced move last week when it increased by 12% on Thursday and then as much as 30% on Friday before giving back 15% of that intraday gain.  That's right; if you bought Lumber Liquidators at the highs on Friday you were down 15% before the day was over.  That is, of course, unless you were trading it with risk controls in place.

Therein lays the pitfall that I am addressing today. 

For trading strategies liquidity plays a major role and for Lumber Liquidators liquidity is horrible.  Specifically, it is very difficult to buy and sell large positions of lumber liquidators without moving the market for that stock significantly.  If you are trying to buy and sell $5000 worth of Lumber Liquidators you're probably not going to have much of a problem at all, but try to buy and sell $1 million or more and you will see that price moves fast and your fills become quite horrible.  This is, in fact, why Lumber Liquidators increased so aggressively on Friday of last week.  Short Sellers were scrambling to exit the stock all at the same time and as they did so the lack of liquidity in shares of lumber liquidators caused the stock to increase by 30% intraday.

The problem I have with this, although I can see the temptation given the relative volatility and the opportunity to make solid returns, is that engaging in relatively illiquid equities will inevitably create serious problems that do not need to exist, at least not to that degree.

Imagine having bought Lumber Liquidators near $21.00 on Friday and you set a stop limit order at $20.90 just in case it moved against you.  If you are trading 100 shares I can't imagine there was much problem getting out, but if you are trying to trade 50,000 shares you suddenly found yourself scrambling to execute a sell order as the stock plummeted.  Odds are you got a horrible fill.

Liquidity matters to trading strategies because without it we get very bad prices.

The two other equities we are discussing are Twitter and UCO.

From a pure volume standpoint Twitter certainly has decent liquidity and it is something that you could trade efficiently, but in my opinion not nearly as efficiently as you could UCO.  You see, when we use ETFs as trading vehicles we empower the liquidity that flash trading provides, and in this case it would be flash trading related directly to oil prices.

In my opinion the best way to avoid the pitfall that is the liquidity trap that many new traders experience is to focus on ETFs that track either the stock market or a very liquid commodity like oil and refrain from individual stocks in most cases.

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