What is Liquidity in Forex market?

Hello friends, Forex traders! We have all heard the phrase “The Forex market is the most liquid market.” What does it mean? What is liquidity? What are the dangers of low liquidity? And, what about the Liquidity of your broker?

In this lesson, we will examine these issues in more details 🙂

The presence of liquidity in the financial markets has a lot of advantages. If the advantages of liquidity are not obvious to you, you should ask anyone who tried to sell the real estate property during the 2008 crisis, or trader, who had an opened position in a wrong direction in a non-trading period before the release of important news that eventually led to a trend reversal. These people were in a situation, where they were unable to get out of the deal when they wanted and where they wanted - and it’s all because of the low market liquidity.

What is liquidity?

Liquidity is the ability to LIQUIDate the assets quickly and without much change in the price. Ie., the presence of high levels of supply and demand.

Imagine that you have an iPhone and you need to sell it. Because iPhone is an extremely popular smartphone, it is very easy to sell it. And note, this does not require much lower price (of course, given that its used). You will sell it fast anyway. Thus, we come to the conclusion that the iPhone is a liquid product: it is easy to buy and easy to sell, because many sellers and buyers are available.

Now, imagine that you have an old grandmother’s cupboard, with peeling paint, creaky doors and numerous cracks. Will it be easy for you to sell it? Hardly. Most likely, you will have to reduce the price considerably. Is Grandma’s cupboard a liquid commodity? Definitely, not. There are sellers, but much less buyers. And, the price will need to be reduced. There is a lack of liquidity in the “Market of grandmothers’ cupboards”

Let’s go back to the currency market.

First, liquidity reflects the interest of market players - both in absolute number of traders and the general trade volume per unit of time. In other words, the presence of a large volume of supply and demand is typical for a highly liquid market. The higher the market liquidity, the faster you can liquidate a large position.

From the perspective of an ordinary trader, the liquidity value is often expressed as a change in volatility. The price on a highly liquid market is moving gradually, in small steps, and quotes are more consistent. EURUSD is one of the most liquid currency pairs, respectively, on the chart, we see almost perfectly smooth movement of prices, despite a small timeframe.

The most traded currency pairs are: GBPUSD, USDJPY, USDCAD, USDCHF, AUDUSD, NZDUSD, GBPJPY and EURJPY.

The reduction of liquidity will lead to large jumps and breaks in the quotes flow. Buy and sell orders volumes in such a period may be changed several times, while remaining small in absolute terms. That is, a situation may occur when the tool continues to depreciate, but there is completely no possibility to sell it.

Forex is often mentioned in the context of the most liquid financial market in general. But, this does not mean that the currency is not susceptible to the impact of liquidity, and this factor must be taken into account even by the forex traders. Generally, for people moving here from other markets, the high liquidity of the Forex is often a pleasant surprise. According to approximate calculations, the daily turnover of the Forex is around $4 trillion.

International trade is constantly in need of large amounts of currency exchange. This causes such a high turnover. It is not surprising that money is the most liquid asset, as here, they can be exchanged for goods, services and other benefits. Of all the currencies, dollar, at the moment, is the most popular one. Let’s start with the fact that the dollar is at least 1/2 of all the major pairs, and 75% of transactions in the Forex is made with those major pairs. So, dollar should definitely be considered.

Liquidity and Volatility

High liquidity does not necessarily mean high volatility. The market may be liquid and low-volatile at the same time.

As we mentioned above, a liquid market moves more smoothly, but low liquidity means more random movements, more chaos. One of the reasons why during the important news releases there are sharp movements into both sides - the absence of liquidity providers on the market that simply do not want to risk. Those sharp movements block the transaction on the news.

Liquidity in different times

The liquidity in Forex changes during the trading day, which is associated with the opening of the main financial centers in different time zones. As it is known, lower level of liquidity is observed during the Asian session. Nevertheless, Japan’s financial reports and comments of local officials may provoke a sufficiently strong market response, simply because less force counteracts the movement of the changed opinions.

In turn, the peak liquidity can be observed at the opening of markets in Europe, and in particular in London. Players activity gradually increases throughout the day, until the time of the North American markets opening. At the close of European trading sessions, liquidity sharply decreases, and declines from the second half of the US session, until the closing of New York.

As already noted, in a period of low liquidity, the market is more vulnerable to unexpected and highly volatile price movements. News or rumors can be the catalyst, which often leads to a spike in quotations and gaps. It is extremely difficult to predict the price movements in such periods, respectively, market risk is also high. At the time of low liquidity of the market, you must always be prepared for the unexpected increase in volatility, if you have open positions.

Liquidity can also significantly weaken due to the holidays and the change in seasonal activity. For example, trading activity falls by the end of summer and before Christmas. As a rule, during such “holiday” trading sessions, the market continues to move by inertia, without exiting the predefined channel.

The situation when there is still a small number of participants on the market is called “thin market”. Large players can use these “weaknesses” to force movement in the direction of the main key levels. In other words, the smaller the liquidity, the easier to “move” the market. Not a rare is the situation, when after such a stagnant market dramatically reverses its direction.

Surely, you’ve noticed that the position closure at night can be very different from the day, and the market is often in a state of flat, in fact, stays in one place. If you are trading on the night flat, always keep the economic calendar on hand, or set up automatic alerts. An hour before the big news, we remove all positions from the market, so you can keep your deposit from the actions of major players.

Broker’s liquidity and the danger of weak liquidity

One of the main advantages of Forex is the ability to quickly exchange. But, having the large amount of currency, you cannot quickly sell it in a period of low trading liquidity, without losing much on trade costs. Also, if you have a lack of liquidity in the market, there are often gaps. Gap is good only when it occurs in your direction. According to the laws of injustice, after the gap position usually goes into a far minus.

If a very small number of people is interested in buying the currency, liquidity falls. Due to this, trading conditions deteriorate. In particular, the spread expands, the difference between the best buying and selling price, and the order glass empties. With high liquidity, spread is shrinking. Provided, of course, that you have a type of account with market performance.

Liquidity of an individual broker is highly dependent on the number of connected suppliers. The more counterparties, the greater the amount they can process. In addition, a large number of applications has a positive effect on the spreads and execution speed - the more applications we aggregate, the best price we can get as a result.

Large positions in highly liquid markets are executed exactly at the stated price. When there is enough volume on the nearest price, the transaction is executed without slippage.

When there is not enough of the volume of the nearest orders applications, the order is partially filled with each of the orders, and the opening price is calculated as a weighted average. That is the position partially executes at 0.76237, 0.76238 and 0.76239, 0.76239 becomes the new best price.

Conclusion

In any case, nobody is protected from sudden volatility jumps. So, do not trust the calm and low-liquid, at first sight, market - looks can be deceiving. High liquidity has much more advantages, making the market more suitable for technical analysis.

A highly liquid market is also a strong market where the forces are roughly equal on both sides, and one major player is not able to significantly influence the price movement.

Remember about this, and profit will be on your side.

Take care, Michael

ForexTraderPortal.com