| When buying or selling shares in a company, most | | | | volume is that it is not necessarily the right factor to |
| traders want to ensure they are doing so at a fair | | | | monitor. For example, For example, some stocks on |
| price. In many cases novice traders fail to get a fair | | | | publicly traded exchanges have extremely high |
| price because they don't understand stock liquidity | | | | valuation, $1000 or more. The stocks can be quite |
| and a factor called slippage. | | | | liquid and one share can easily be bought. So you can |
| What is slippage? | | | | see that trading volume is actually irrelevant. What is |
| Slippage is the difference between the last trade | | | | important is average dollar-volume. In other words, |
| price and the price realized by the next order. | | | | concentrate on the $$$ turned on an average trading |
| Typically, slippage occurs when there is a significant | | | | day, not the volume of stocks traded. |
| imbalance between demand and supply. For example, | | | | The minimum stock liquidity for stocks the trader is |
| if a stock trader wants to buy 10000 shares of a | | | | interested in buying should be based on trading capital |
| stock but the average daily volume shares traded for | | | | and number of stocks held. For the case mentioned |
| that stock is 5000 shares, then there will likely be a | | | | above the trader has $100K trading capital and wants |
| great deal of slippage in acquiring the stock. The act | | | | to hold at least twenty stocks. On average each |
| of buying the stock will drive up the share price | | | | position will be $100,000 / 20 = $5,000. When you |
| because there are not enough willing sellers. | | | | buy a stock, a good rule of thumb is to buy no more |
| One method of preventing slippage is to use limit | | | | than 1% of the 60 day average daily dollar-volume. |
| orders instead of market orders. But there is a | | | | For this trading example, the minimum stock liquidity |
| downside to this. Quite often the stock trader does | | | | level should be a minimum $500,000 daily average |
| not acquire the best stocks with limit orders because | | | | traded for a particular stock. |
| the price moves up too fast. Or the trader will get | | | | Market Capitalization |
| filled on a miniscule number of shares and has to | | | | Now the average dollar-volume is fine for acquiring a |
| chase the stock by moving up the limit price to | | | | stock position but what about exiting? When a sell |
| acquire more. Neither of these situations are desirable. | | | | signal comes up the trader will have to sell regardless |
| Stock Liquidity | | | | of the average dollar-volume. In preparation for selling |
| When developing a stock trading system, it is good | | | | a stock, consider using market capitalization as a filter |
| practice to determine the minimum stock liquidity for | | | | before buying the stock. The idea is that if the |
| your needs. For example, if a stock trader starts | | | | market capitalization is too low then stock liquidity is |
| with $100K trading capital and plans on holding 20 | | | | likely a problem, even if the dollar-volume is high. This |
| different stocks then he will typically be buying $5K | | | | provides some buy side filtering for consideration of |
| worth of stock at a time. To avoid major slippage | | | | ultimately selling the stock. |
| problems the stock trader will likely set certain | | | | Stock Price |
| minimum stock liquidity requirements to filter out low | | | | The final parameter to consider is the current stock |
| liquidity stocks. | | | | price. It is a good idea to avoid stocks trading under |
| Average Trading Volume | | | | $3. There is too much speculation/manipulation for |
| Many novice traders will filter out low liquidity stocks | | | | these stocks and they tend to be less liquid. |
| by examining the stock average trading volume over | | | | Conclusion |
| the previous 20 days. 20 days is generally not | | | | To avoid having excess slippage when entering |
| sufficient as a large volume spike on one or two | | | | trades, make sure you consider the stock liquidity |
| days can skew the average trading volume. You can | | | | (average dollar-volume), market capitalization and |
| end up holding a stock with volume dying off rather | | | | stock price. If you want to trade more than 1% of |
| quickly. So it is better to a longer averaging period | | | | the stocks average dollar volume then consider |
| such as 60 days. | | | | breaking the trades into several different orders to |
| Average Dollar-Volume | | | | manage slippage. |
| An issue with examining the average daily trading | | | | |