The importance of liquidity in forex trading can not be denied since it is a key factor in making a trade potentially profitable. Greater liquidity in a financial market facilitates transaction flow and increases pricing competitiveness.
The provision of liquidity is important for well-functioning asset markets, primarily in the case of forex trading. In this article, I will share my words on liquidity, how it works, and the factors that make a certain asset more liquid.
The ability of a currency pair to be bought and sold without a major influence on its exchange rate is referred to as forex liquidity. When a currency pair can be traded (buy & sell) easily, and there is a significant trading activity for that pair, it is said to have a high level of liquidity.
The liquidity of a market refers to how active it is. It is determined by the number of active traders and the total volume of trades. One reason the foreign exchange market is so liquid is that it is open for trading 24 hours a day, five days a week.
It is also a tremendously liquid market, with more than $6 trillion in daily turnover. Although liquidity fluctuates as financial centres across the world open and close during the day, there is usually a relatively high time of forex trading going on at all volumes.
Market liquidity is important for several reasons, the most important of which is that it impacts how quickly you may open and close positions. Some professionals believe that a liquid market is typically associated with lower risk since there is always someone willing to take the opposing side of a particular position.
This can draw speculators and investors to the market, adding to favourable market conditions. In a liquid market, a seller will quickly find a buyer without cutting the asset’s price to make it more attractive. On the other hand, a buyer will not have to pay a higher price to secure the asset they desire.
The liquidity of an asset is also a key factor in determining the spread that a leveraged trading provider may offer. High liquidity means many buy and sell orders in the underlying market.
This raises the likelihood that the highest price a buyer is willing to pay and the lowest price a seller is willing to accept will move closer together.
Since we derive prices from the underlying market, a lower bid-offer spread here will translate into lower spreads offered on the platform. If a market is illiquid, it may indicate a wider spread.
When trading major currency pairs, you are trading in an exceedingly liquid market. You are, however, trading based on the available liquidity of financial institutions, which allows you to enter or exit the trade (currency pair) of your choice.
Not all currency pairs are liquid. In reality, currencies’ liquidity varies depending on whether they are major, minor, or exotic pairs (including emerging market currencies). Forex liquidity dries up when traders shift from major to minor pairs to exotic pairs.
In forex, high liquidity refers to a currency pair that can be bought/sold in significant sizes without large variances in its exchange rate (price level) – for example, major currency pairs such as EUR/USD.
Other major currency (highly liquid) pairs to be aware of:
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Low liquidity in forex refers to a currency pair that cannot be bought/sold in significant amounts without large fluctuations in its exchange rate price level, such as PLN/JPY.
An illiquid market exhibits chaotic moves or gaps because the buying or selling volume level at any given time might vary. A highly liquid market is also characterised as a deep or smooth market with smooth price action. Most traders demand a liquid market since it is extremely hard to manage risk when you are on the wrong side of a big move in an illiquid market.
Here are three signs to look out for:
Forex spreads differ from other markets. However, price gaps in forex might occur if an interest rate announcement or other high-impact news announcement falls short of expectations.
Gaps might occur during the week’s opening on Sunday afternoon in the United States. If a news announcement occurs over the weekend, the forex gap is usually less than 0.50% of a currency’s value.
Because of the continuous nature of the equities market, a market that trades 24 hours a day, such as a forex market, is deemed more liquid or simply has fewer gaps. This allows traders the discretion to enter and exit the market at their ease.
A market that only trades for a fraction of the day, such as the US equity market or the Futures Exchange, would be condensed into a thinner market because the price might jump at the open if overnight news comes to the crowd’s expectations.
Brokers frequently include a “volume” option on the chart, allowing traders to assess market liquidity. The bars on the volume chart are analysed to comprehend this forex liquidity indicator.
Each volume bar represents the volume traded during the specified time period, providing the trader with a reasonable approximation of liquidity. It is important to remember that most brokers only reflect their own liquidity data, not the overall liquidity of the forex market. However, depending on the size of the broker, using liquidity as a gauge can accurately represent the retail market.
Short-term traders or scalpers should know how forex liquidity varies during the trading day. There are hours with low activity, such as the Asian Session, which is frequently range bound, implying that support and resistance levels are more likely to hold from a speculation standpoint.
Breakouts and larger percentile moves on the day are more likely during the major moving market sessions, such as the London and US sessions.
The US morning session is likely to see the most movement because it overlaps with the European / London session, which accounts for roughly +50% of total daily global volume.
The US session alone accounts for roughly 20%. In the US afternoon, there is frequently a sharp drop off in aggressive moves unless the Federal Open Market Committee (FOMC) makes a surprise announcement, which comes only a few times a year.
In financial markets, the connection between risk and reward is usually always proportional; therefore, recognizing trade risks is essential.
The Swiss Franc crisis in 2015 is a primary example of liquidity risk in the forex market. The Swiss central bank announced that the Swiss Franc would no longer be pegged to the Euro, causing the interbank market to collapse due to an inability to price the market.
As a result, brokers were unable to provide liquidity on CHF. As interbank pricing (the foundation of forex pricing) returned, EUR/CHF prices exceeded the previous range. This significantly impacted retail client account balances for those trading in CHF. While “Black Swan” incidents are rare, they are not impossible.
Retail forex traders must manage liquidity risks by lowering their leverage or using guaranteed stops, in which the broker is obligated to honour your stop price level. Weighing the options between liquidity risk and reward should not be overlooked and should be part of a trader’s analysis routine.
When trading financial markets, liquidity must be considered before opening or closing any position. This is because a lack of liquidity is frequently associated with increased risk.
When the market is volatile, with fewer buyers than sellers, it might be more difficult to close your position. In this situation, you risk being stuck in a losing position, or you may have to travel to multiple parties with different prices merely to satisfy your order.
Guaranteed stops, a type of stop-loss that ensures your position is closed at your pre-selected price level, are one technique to manage liquidity risk. Guaranteed stops are not impacted by volatility and can be useful for navigating tumultuous markets. However, if your guaranteed stop is triggered, you will have to pay a small fee.
The most important thing to remember is that market liquidity is not always fixed; it operates on a dynamic scale ranging from high to low liquidity. The position of a market is determined by several factors, including the volume of traders and the time of day.
If you trade an overseas market or a market after hours, you may discover that there are fewer market participants and hence lower liquidity. During Asian trading hours, for example, there may be reduced liquidity on GBP forex pairs. This may lead to wider spreads than during European trading hours.
The trading volume is the overall number of hours an asset is exchanged during a specific time period. It is often estimated for exchange-traded assets such as commodities, futures, currencies, securities, and stocks. The trading volume includes both the total value of the asset bought or sold during the transaction and the number of transactions that are taking place.
The trades always provide volume charts based on the timeframe chosen. Multiple charts, from minute to monthly, may be seen, and modern platforms even offer customisable durations. It’s worth mentioning that the daily report issued after market close is more exact, whereas hourly volume figures are typically based on assumptions.
But what does trading volume even indicate, and why is it important? We say the volume is high when there are a significant number of traders in the market. Although this does not always imply that all traders will take the same positions, it usually indicates a trend.
The market price necessarily follows the same direction as trading volume, but this does not always imply that high volume equals high prices because there might also be numerous sellers.
A high trading volume is regarded as a substantial advantage. The more buyers and sellers there are on the market, the more likely you will find a counterparty for your trade at your selected price. Tighter spreads are also associated with greater volume.
Reduced liquidity, on the other hand, will result in lower volume, implying fewer buyers and sellers on the market. Low liquidity may be dangerous and result in a loss of money if the market moves against you since it might leave you in positions where exiting the trade is difficult.
Volume trading in forex is slightly different from volume trading in other asset classes. The amount of money transferred from sellers to buyers in foreign exchange trading is the number of lots traded in a currency pair within a specified time frame.
Volume has become critical because liquidity is directly tied to a trader’s ability to open and exit trades at their chosen price and is heavily dependent on it.
Spreads and currency pair volatility serve as liquidity indicators for retail traders. A market with high liquidity experiences frequent changes in quotations per unit and price movement, with periodic pullbacks. In low-liquid markets, dramatic price spikes and fast quotation changes over a short time are prevalent.
One of the factors influencing forex liquidity is the volume of currency pairs traded on the exchange. It should be noted that the US dollar is the most widely used currency in the world, accounting for the great majority of the volume. The most liquid pairs against the dollar and other major foreign currencies include EUR/USD, GBP/USD, USD/JPY, USD/CAD, USD/CHF, and AUD/USD.
The larger the volume of currencies on the market, the closer the supply and demand prices are. When it comes to spreads, the liquid pairs have the smallest. For example, the EUR/USD pair always has the lowest spread.
The foreign exchange market is open 24 hours a day, five days a week. During working days, volatility and forex liquidity vary depending on the trading session. The major financial hubs cannot function concurrently due to their different time zone locations. For example, Japan, Australia, and China are Asia’s top financial centres.
Peak activity happens while the American and European markets are open. As the European session comes to a close, liquidity usually falls. Liquidity falls during state holidays and the holiday season. Thin markets are the term used to describe these market conditions.
Although prices in a thin market normally move in a narrow range, price outliers might occur from time to time due to unexpected economic data. Low liquidity makes predicting price movements more difficult, making trading undesirable during these times.
Several different factors influence the forex market. These factors include market conditions, GDP, unemployment rates, foreign trade, and other data.Can you lose more than you invest in forex? - Depends — 2023
You must be aware of numerous events and factors while trading forex. As a result, different signals must be considered. You must know vital information about a specific currency when you get involved in a specific trade.
During your trading period, you must keep a close eye on global economics and geopolitics. You may miss significant moves if you are late and do not execute before a specific report is released. Monitoring online resources for FX-related news is thus highly recommended. You might check official economic calendars or forums where other traders exchange valuable information.
All of the information can help you maintain track of the global economy. These calendars feature important real-time global trading environments and financial/economic events that might significantly influence forex liquidity and the overall market trend.
Being continually aware of all the aspects influencing the foreign exchange trading market would be a difficult task. Their significance varies depending on the context. However, anyone with access to the information can use it to their advantage. A currency trader has the opportunity to respond to any available data immediately.
Compared to other markets, one factor that significantly impacts forex trading is the ability to perform transactions virtually anywhere in the world. Because forex is the largest, most decentralised, and global region, it attracts traders and institutions worldwide.
When we examine the world’s financial hubs, such as the United States, Japan, or the United Kingdom, these countries have the most significant GDP data affecting currency trading.
Central banks significantly affect the currency market because of their role in adjusting the country’s interest rate. To create a favourable interest order balance, a central bank must sustain economic growth at pace with inflation.
The forex market, in which the value of a currency or group of currencies fluctuates in real time, is propelled by speculation due to bank decisions on whether to raise, lower, or maintain interest rates. Aside from state authorities and their decisions, additional factors such as natural disasters, terrorist acts, and military conflicts can significantly impact the FX market.
To trade volatile currencies, you must thoroughly understand the forex market. However, investing in highly liquid and somewhat volatile currencies is highly recommended if you are just getting started in forex because it carries less risk.
You should also pay close attention to the regular updates so that you are familiar with the aspects influencing forex market volatility and liquidity and can execute profitable trades.
The major purpose of this article was to show you how crucial forex liquidity is to the currency market. While dealing with very liquid instruments increases your chances of making profitable trades, neglecting liquidity may hurt your trading experience.
It is wrong to believe that only “seasoned traders” with large amounts of cash and trading volume should consider liquidity. Liquidity is undoubtedly important for professionals, but beginners should also be aware of it.
Trading with major currencies such as the Euro, US dollar, Japanese yen, and others is more liquid and dependable than trading with exotic pairs. When you initially start trading on the financial markets, you should invest in currencies with high liquidity to grow trading volumes quickly.
Yes, in a nutshell, high liquidity in forex is good for both buyers and sellers.