Liquidity Scenarios: Planning for Thin Air

Backtests assume liquidity that disappears when markets panic. Quotes thin out, spreads widen, and exit costs explode.

Scenario tests model how fills evaporate and what it costs to unwind positions when volume vanishes.

Why it matters

Liquidity shocks turn theoretical P&L into realized losses. Without planning, forced exits happen at the worst prices.

Common mistakes

• Assuming yesterday’s depth persists in stress.
• Using average spreads in crisis simulations.
• Ignoring the cost of liquidating correlated positions.

Implementation steps

Model depth curves

Vary order book depth and spread assumptions in scenarios.

Plan exit thresholds

Define halts or size reductions when liquidity metrics breach limits.

Maintain buffers

Hold cash or hedges to avoid fire-sale liquidations.

LiquidityAI tie-in

• Scenario studio simulates depth collapses and impact costs.
• Policies enforce halts when liquidity thresholds fail.
• Dashboards compare planned exits to live conditions.

Case sketch (composite)

During a flash crash, a portfolio that pre-modeled liquidity cuts positions gradually, avoiding a 7% gap that hit unprepared peers.

Takeaways

• Liquidity assumptions must be stress-tested, not assumed.
• Predefined triggers prevent panic exits.
• Buffers buy time when markets go dark.

LiquidityAI provides tools and education for systematic trading. This article is for informational purposes only and does not constitute investment advice. Trading involves risk, including possible loss of principal.