Why Is Liquidity so Important?
Liquidity: One of the Key Advantages of Forex Trading
One of the main important features of forex trading is liquidity. The forex market is the most liquid financial market in the world with approximately $5.1 trillion dollars flowing into the market daily.
Liquidity measures the market activity based on how many people and how much volume is being actively traded. The forex market is very active mainly because it works 24 hours a day during the week. Although the liquidity in Forex pairs can fluctuate along the day, as the financial centers open and close, there are always high volumes of transactions happening in Forex.
When referring specifically to currency pairs, liquidity measures how quickly a currency pair can be bought and sold, in other words, a currency pair is liquid when there is a high supply and high demand for that specific asset. In Forex not all the currencies pairs show high liquidity, exotics pairs, for example, which includes emerging countries currencies, are not traded as frequently as major pairs and consequently are not liquid.
High Liquidity Pairs vs Low Liquidity Pairs
Major currency pairs are the most popular traded currency pairs and are responsible for the majority of the forex market transactions.
There is no specific definition for majors, but they are usually referred to any pair containing the US Dollar and one of these currencies Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD), Australian Dollar (AUD).
They are pairs with very high liquidity since the larger the trade amount between the two countries, the more liquid the currency pair will be.
This high liquidity is not related to only the amount of volume used during economic transactions (high supply and demand) but also for the pair being traded by speculators and investors. Another factor that contributes to the liquidity of these currencies are their countries’ political and economic stability.
Greater liquidity is also related to smooth volatility in general, meaning they usually don’t move as quickly as other currency pairs. Traders can expect less surprises compared to the exotic pairs trading.
Low liquidity pairs are currency pairs that are not traded as frequently, which means there is not always a high number of buy and sell orders in the market and as a consequence have higher spreads and variations in the price.
How to identify liquidity in the Forex Market?
When trading forex is very important to manage risks to increase the chances of successful trades. Liquidity is a factor that should be constantly analyzed since it is not stable and changes throughout the day and directly affects your positions.
Liquidity can not only vary according to the pair traded, but it also depends on several components that can increase or decrease the number of sellers and buyers in the market, affecting the spreads, prices and the ability of your order to be filled.
Here are some factors that can help to predict liquidity levels:
1) Gaps
Traders should be aware of potential market gaps that happen in forex. Gaps are periods in the chart which the price sharply moved with no trading occurring in between.
Gaps usually occur on the weekends, when the forex market is closed and also during high impact economic news, mainly if the economic data goes against market’s forecasts.
As the forex market is open 24 hours, it exhibits less gaps than Futures markets for example. However, traders should still look out for signals of market gaps, since it is a moment of the day with low liquidity, which can cause your order to be filled at a worse price than you expect, being hard to manage the trades.
1) Liquidity Indicator
Traders should be aware of potential market gaps that happen in forex. Gaps are periods in the chart which the price sharply moved with no trading occurring in between.
Some brokers offer a forex liquidity indicator that allows traders to monitor volume traded of an specific pair on the charts, having a sense of liquidity in the market for that specific time in that particular broker. Although the indicators don’t measure the universal market liquidity, the traders can use it as a ‘liquidity thermometer’.
3) Trading Time
The liquidity in the market is also affected by the time of the day the trade is taking place. During the Asia session hours, the markets are usually less active, which means that not so many transactions are taking place, less liquidity is flowing into the markets.
The London session happens between two major sessions, consequently this session usually has high liquidity and lower spreads. The major pairs are heavily traded during this session.
The New York session opens when the London markets are still running, for this reason, these are the trading hours with most liquidity. Most economic reports are released during this session.
Liquidity: Risk vs Reward
Forex markets can be unpredictable since the currency rates are influenced by many political and economic factors. Traders need to understand the risk and reward that comes with liquidity.
High liquidity means that the markets tend to move slower, with less abrupt price changes, consequently your orders will be easily filled, resulting in a less volatile market. While low liquidity increases your risks, since the market is fluctuating drastically, it also increases your rewards, being very interesting for day traders.
