WSJ: Thin Liquidity in Stock Futures Raises Risk of More Wild Market Moves

Trading conditions have sharply deteriorated in a popular vehicle for betting on swings in the S&P 500, exacerbating the volatility in the stock market in the past two weeks.

E-mini S&P 500 futures play a huge, if little understood, role in financial markets, with hundreds of billions of dollars of trading activity each day. They track the S&P 500 and typically move in lockstep with the broad-based index.

For reasons that aren’t fully clear, liquidity in the E-mini market has been unusually depressed during the past two years. It eroded to near record lows during the coronavirus-fueled selloff of late February, and it is still thin—a sign of potential turbulence going forward.

For most of 2017, the average number of E-mini contracts available to be bought or sold within a tight band around their current price, corresponding to a one-point move in the S&P 500, hovered between 3,000 and 6,000, Deutsche Bank data show.

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But over the past two years, that number has rarely climbed above 2,000 contracts. On Friday, it fell to just 163 contracts—down more than 80% from a week earlier—before slipping even further, to 132 contracts, on Tuesday, according to Deutsche Bank.

The term “liquidity” refers to the ability to execute a big trade without affecting the price of an asset. In layman’s terms, lower liquidity means that when a wave of selling hits a particular market, prices drop more sharply than they would have otherwise. In the case of the E-mini, heavy selling has a knock-on effect on the stock market itself—and on investors’ portfolios.

There are various ways to measure liquidity, and it is a matter of debate which is best. A simple approach is to look at the trading volume of a particular market. By that standard, liquidity in E-minis has never been better, hitting a record on Friday with more than $850 billion traded that day.

But the liquidity metric tracked by Deutsche Bank’s analysts—the number of contracts available to be bought or sold—offers a measure of how fragile a market is. When there are lots of traders posting quotes to buy E-mini contracts, they effectively act as a buffer against sellers putting downward pressure on the S&P 500.

And by that standard, the buffer is now very thin.