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Lack of Liquidity in E-Mini S&P 500 Futures Could be a Sign of Fragile Market

This article was originally published on ETFTrends.com.

Trading E-mini S&P 500 futures represents a $200 billion market, and some traders are noticing a lack of liquidity, which could put the stock market in a fragile state should a sharp downturn take place.

It's something that traders who play in this nuanced market have been picking up on since last year's fourth-quarter volatility that racked the markets and led to massive sell-offs culminating on Christmas Eve. Futures activity tracking the S&P 500 index is typically impacted prior to hitting the stock market.

As such, lesser liquidity in these E-mini S&P 500 futures could infect the general stock market, making it more susceptible to large swings in prices--up or down.

“Particularly if the market goes one way, that impact is going to be exacerbated in either an up move or a down move,” said Hallie Martin, a strategist with Deutsche Bank in New York.

Typically, liquidity thins in E-mini S&P 500 futures when markets are facing pressure, but returns when markets eventually stabilize. As such, that lack of liquidity is what's making these traders fret.

“The weird thing is that markets haven’t been that volatile this quarter, but order-book depth hasn’t really recovered,” said Hovannes Jagaspanyan, an algorithmic trader in the Chicago office of Quantlab, a high-speed trading firm.

Low Volatility Warnings

Lesser volatility and quieter markets, however, doesn't necessarily translate to a healthier stock market.

U.S. equities are off to a stellar beginning to 2019 and the volatility that reared its ugly head near the end of 2018 has been missing. However, according to a Wells Fargo recession model, this is could be the calm before the storm.

The Wells Fargo recession model is eerily reminding investors of 2008. The model, which uses a mix of spreads from Treasury yields, is showing that a chance of a recession jumped above 40 percent in January.

The concept is difficult to fathom given that market volatility is down, but according to analysts, this is where the red flag begins waving.

“Despite the increased recession probability, long-dated equity volatility is actually trading lower than in previous years,’’ Pravit Chintawongvanich, a Wells Fargo equity derivatives strategist, wrote in a note.

This disconnect between volatility and recession probability hearkens back to the financial crisis in 2008.

“In 2007, 1-year vol traded at very low levels despite recession risk having increased rapidly in 2006,’’ Chintawongvanich wrote. “It was only when Bear Stearns started running into trouble in summer 2007 that 1-year vol rapidly repriced.’’

If the markets are indeed poised for a rocky ride ahead, traders can take advantage of market oscillations with leveraged S&P 500 ETFs, such as the Direxion Daily S&P 500 Bull 2X ETF (SPUU) , Direxion Daily S&P500 Bull 3X ETF (SPXL) for gains and the Direxion Daily S&P 500 Bear 1X ETF (SPDN) for declines.

Other ETFs to Consider

If a market shock occurs, will large cap equities be in better shape versus small cap equities?

For investors looking for continued upside in large cap equities over small caps, the Direxion Russell Large Over Small Cap ETF (RWLS) offers them the ability to benefit not only from large cap equities potentially performing well, but from their outperformance compared to their small cap brethren.

Conversely, if investors believe that small cap equities will outperform large cap equities, the  Direxion Russell Small Over Large Cap ETF (RWSL) provides a means to not only see small cap stocks perform well, but a way to capitalize on their outperformance versus their large cap brethren.

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