Question

Some hedge funds make money by providing liquidity to the market. Discuss. Support your answer with examples.

Answer 1

Providing liquidity involves purchasing assets from hedge funds, or having assets to sell. Markets need liquidity to remain accurately priced-think about any market that fails to accurately value assets-property, gold, tulips, even groceries-such price failures are usually caused by illiquidity-a shortage about inventory or buyers. In the stock market-the most important characteristic of well run, efficient pricing is precision pricing. Without hedge funds buying and selling-you might very well go out selling a stock and not find a buyer-causing you to sell at a much lower price than the assets currently represent or wait days to find a buyer.

Liquidity defines the extent to which an asset or commodity may be acquired or sold on the market, without changing the price of the asset. Whenever you want to make a deal, whether it's buying Apple stock for your retirement account or making a trading account short of December 2018 WTI crude futures, you need to find somebody to take the other side of the trade (for you to buy AAPL someone has to want to sell it to you). It is said that the person who is willing to take the other side of your trade will provide you with liquidity so you can buy or sell the particular asset.

Typically, this liquidity provider is a market maker (typically a hedge fund, bank, or prop trading company) and will typically provide 2-way liquidity for a price (bid / ask spread). AAPL stock, for example, closed today at around $140.50/share. If you were looking to trade AAPL shares after hours right now, a market maker could provide you with liquidity by offering you a 2-way market for a specific size trade, e.g. 140.45 bid for 1000 shares at 140.55 bid. This means they'll buy up to 1000 shares for 140.45 a share from you if you want to sell AAPL. Even if you want to buy AAPL they 're going to sell you up to 1000 shares for 140.55.Either way you are usually subject to paying the spread to take the liquidity they've provided.