What Is a Sold-out Market?
In finance, the term "sold-out market" refers to a situation in which most investors have already sold or closed out their positions. As a result, the market may lack the liquidity necessary to remain viable.
A common example of a sold-out market would be when a commodity futures contract has passed its execution date. In those situations, trading in the contract ceases as buyers and sellers will have moved to the subsequent months' futures contracts.
- A sold-out market is a condition in which there is not enough liquidity to support normal trading.
- It can arise in certain derivative markets where the assets in question have set expiration dates, as well as in smaller markets with relatively few participants.
- Sold-out markets rarely arise within centralized exchanges, particularly when those exchanges are supported by market makers who provide additional liquidity.
How Sold-out Markets Work
In a sold-out market, most or all of a contract's long positions—that is, traders who had purchased and held the asset—have already been sold or liquidated. This produces an increasingly tight liquidity environment in which new buyers might struggle to find supply at reasonable prices.
In some cases, a sold-out market might lead to a complete end to trading, such as in the case of futures or options contracts that have formally expired.
Sold-out markets usually occur in markets where the assets either have defined expiration dates, or where the market in question is relatively small. For example, derivatives such as options or futures might see increased activity as their expiration date nears, but this activity will then sharply decline and then cease once the date has passed.
Generally speaking, if a market has a large number of players, it is less likely to become sold-out. The presence of a diverse range of participants, such as a mix of industrial buyers and speculators, can also help maintain market stability.
On organized exchanges such as the New York Stock Exchange, it is rare to see sold-out market conditions. Typically, there is enough liquidity to facilitate trades since major exchanges often have an abundance of liquidity providers who will make an offer to any buyer in the market. Chief among these are the institutional market makers, financial firms who maintain an inventory of various assets and step in to provide liquidity if the organic trading volume declines below a certain level.
Real-World Example of a Sold-out Market
Consider the case of a yogurt producer who wants to hedge their price risk using forward contracts. Unlike futures contracts, these contracts can be customized between the parties involved, trading on an over-the-counter basis rather than on a centralized marketplace such as the Chicago Mercantile Exchange. By using forwards, the yogurt producer locks in their selling price three months in advance to protect themselves from any potential price declines during that period.
The yogurt producer's counterparty in this transaction is a local supermarket chain. By agreeing to buy this forward contract, the supermarket chain agrees to lock in the price they pay for yogurt from this producer for the next three months, thereby protecting themselves from the risk that prices will rise during that period.
Over those three months, however, several new yogurt producers decide to enter the market. Like the original producer, these new yogurt producers want to hedge their risk exposure by selling futures contracts. However, the supermarket chain has already hedged all of its risk and is unwilling to sell any more forward contracts, which would actually increase their own risk exposures since they are already fully hedged. As a result, these new yogurt producers confront a sold-out market in yogurt forwards and are unable to hedge successfully.