The rate at which market prices fluctuate is known as its volatility. The volatility of market prices is strongly influenced by the market’s liquidity. When there is less money in the market, prices tend to fluctuate wildly. When there is more money in the market, prices don’t tend to change as much.

Since higher liquidity translates in lower volatility, liquid markets like forex tend to move in smaller increments. When there are many of buyers and sellers at the same time, prices tend to fluctuate slightly. The foreign exchange market can see rapid and unexpected shifts, though. There are various factors that contribute to currency price fluctuations, including political, economic, and social events. Traders who are aware of the market and the news can uncover opportunities for profit and mitigate risks. To help you better understand Forex Volatility, we have compiled this definitive guide.

What is volatility in Forex trading?

Currency price volatility is a key indicator in the foreign exchange market. Trading a currency with a high volatility level in the Forex market carries a higher risk. Trading extremely volatile currency pairs, however, opens you up to the possibility of massive profits. The volatility of the most traded currency pairings is lowest, while that of the more exotic ones is highest.

What causes volatility in Forex?

Given the current state of the global markets, the nature of interconnected trades, the ease of information and communication, and the widespread use of social media and digital technology, market experts agree that market volatility is at the forefront of every trader’s mind. Some factors to keep in mind are:

Interest rate changes

When interest rates shift, so does the volatility of the foreign exchange market. If the interest rate of an economy rises, investors will be less likely to put money into it. This would lead to a sharp decline in the value of the domestic currency and increased volatility in the foreign exchange market.

The world’s central banks play a crucial role in regulating the global monetary system. By controlling interest rates, they can manage the supply of money. Forex traders all across the world, from the United States’ Federal Reserve to Europe’s ECB, Britain’s BoE, Japan’s BoJ, Canada’s BoC, and Australia’s ARB, keep a close eye on policy moves made by their respective central banks.

Similarly, a decrease in the interest rate would encourage consumers to spend more now that they have more disposable income, which in turn would cause an increase in the value of the domestic currency on the market.

Economic shocks affecting supply and demand

Foreign exchange volatility can also be negatively impacted by domestic shocks such as a shift in taxation policy or a sharp increase in energy costs. For instance, if a country imposes significant taxes on commerce, severely affecting a large portion of the consumers, fewer people would participate in the Forex market, causing currency pair values to fall and volatility to increase.

Trade conflicts, whether they involve the United States and China, the United States and Europe, or any other area or country, can increase market volatility because of the enormous volume of money changing hands. The currencies at stake in a trade war are bound to be impacted in some way.

In a similar vein, if domestic oil prices rise due to excessive demand, this may cause a rise in the value of the currencies of Gulf States, as these nations will be able to supply more oil and earn more money as a result. This would again cause significant fluctuations in the value of international currencies traded on the Forex market.

Global changes and events

The volatility of the Forex market can be significantly impacted by a number of worldwide changes and events, including political elections, natural catastrophes, wars, and similar occurrences. A government change is seen as a change in the political attitudes of the nation, which can create volatility to the market, thus most traders would avoid investing in the currency of a country that is about to hold elections.

Trader and market sentiment

Market movements are driven by the people behind them. Traders and investors around the world make markets move. And depending on the prevailing sentiment, whether positive or negative, market volatility can fluctuate.

How to identify currency volatility?

Due to its inherent unpredictability, currency volatility is notoriously difficult to detect and monitor. However, there are ways to quantify volatility that might aid investors in making informed predictions.

It is important to include both historical volatility and implied volatility for a precise assessment. Volatility has always existed, but the price of futures options reflects traders’ predictions for the future, which is represented as implied volatility.

Volatility over time can be viewed in charts, where the peaks and valleys in prices are readily apparent. Traders can use the four CBOE indexes that track market expectations of currency volatility for calculating implied volatility.

What are some of the most volatile currency pairs?

There are some currency pairs that are more volatile than others.

AUD/JPY

Many investors use the AUD/JPY exchange rate as a gauge of risk. If risk appetite is strong, investors will be interested in purchasing the Australian dollar. However, when markets are in a “risk-off” posture, the Japanese yen, a traditional safe haven, will attract buyers. This makes the AUD/JPY a highly speculative pair of currencies, as its value will rise when investors are feeling risk-seeking and will fall when they are becoming more risk-averse.

GBP/CAD

The exchange rate between the British pound and the other major currencies is typically the most volatile. As a major oil producer, the Canadian Dollar, like the Australian Dollar, is a “risk-on” currency that follows the movement of the oil price closely. The Canadian dollar could be severely impacted if markets go into “risk-off” mode at the same time that oil prices are declining. The opposite is true: the currency does well when both commodity prices and the appetite for risk are high.

USD/TRY

Geopolitical factors, as well as the volatility of the Turkish Lira’s central bank and the impact of politics, contribute to the currency’s unpredictable trajectory.

Forex market volatility trading tips

Knowing the inherent nature of volatility and the factors behind it, how can you use it in your favour? How can you harness volatility in your forex trading? Some tips are as follows:

Trade Using Charts and Indicators

Various technical indicators can be used to gauge market sentiment and forecast future price movement. Charts and indicators, while not conclusive, will aid you in developing a trading strategy and determining entry and exit points.

Use stop loss orders

Stop losses are useful in any trading situation, but they take on added significance when dealing with volatile currencies. Stop losses allow you to plan ahead for lost transactions and limit your potential losses to an amount that is comfortable for you. If you trade with leverage, you stand a significantly greater risk of losing more money than you initially deposit, making this a must-read.

Monitor the economic calendar

You can predict market volatility to some extent if you keep an eye on the economic calendar and familiarise yourself with the important economic events and choices that have the potential to affect the markets. Remember that volatility is inherent to the markets. The test for you as a trader is how you respond to it.

When there are significant events that could increase volatility, some investors choose to take a pass. However, there are other market participants that want to profit from the price fluctuations that accompany such landmark occasions. No matter your trading style, it pays to stay on top of the most important developments. To keep up with these big events, it is important to learn how to read the economic calendar.

Keep Position Size Low

In the highly volatile forex market, both large gains and losses are possible. Any trader dealing with volatility would be wise to keep their position size small. Keep your open deals to no more than 5% of your trading capital. Your location will have greater leeway to manoeuvre, and your resources won’t be depleted as quickly.

Limit your leverage

By now, you should realise that leverage can work both ways. Both your successes and failures may be amplified. Reducing the leverage on your transactions is an early step in the direction of risk management.

Keep A Trading Journal

Keeping a trading journal to record your transactions is a highly recommended practise. It’s especially helpful when dealing with the unpredictable forex market, as you can review your past trades and determine what worked and what didn’t. You may develop as a trader by constantly evaluating, reflecting, and improving the way you trade with the help of a well-kept trading notebook.

The difference between volatility and risk

There are variations between volatility and risk. For risk, you can select how much you can handle, but volatility is out of your control. However, their bond is strong. Trading volatile currencies is risky since prices can change suddenly. This big fluctuation magnifies gains and losses.

Forex traders often take a risk on a volatile market because others are doing so. Traders may sell low during a market meltdown, risking large losses. You must constantly consider risks and advantages and drawbacks before trading, especially in unpredictable markets. Never trade based on popular opinion; utilise your own risk management approach to trade with a risk you can afford.

How liquid a market is reflects how active it is. The number of traders actively trading and the overall volume they are trading decide it. During the weekdays, the foreign exchange market is open for trading 24 hours a day, which contributes to its high liquidity. With a daily transaction of close to $6 trillion, the market is also extremely deep. Although liquidity varies as various financial centres open and close during the day, there are typically constant, high volumes of forex trading.

Because of their great liquidity and low volatility, liquid markets like forex usually move in smaller steps. The price typically moves somewhat up and down when there are several people trading at once. However, the currency market is likewise susceptible to abrupt and dramatic changes. Since there are so many political, economic, and social events that have an impact on currencies, many different things can cause values to fluctuate. In order to uncover possible profit and to better avoid potential loss, traders need be aware of current affairs and stay up to date on financial news.

It’s imperative to understand the fundamentals of forex liquidity if you’re interested in forex trading. For traders to make wise decisions and effectively navigate the foreign exchange market, they must have a solid understanding of market liquidity. With its enormous daily trading volume and ongoing price volatility, the forex market presents profitable chances for traders all around the world. To win in this fast-paced environment, you must, nevertheless, comprehend the idea of forex market liquidity and its significant influence on trading results.

What is liquidity in Forex?

One of the first benefits of forex trading that a trader is likely to encounter is the forex market’s greater liquidity than other marketplaces.

In the forex market, a currency pair’s liquidity refers to its capacity to be purchased and sold without significantly changing its exchange rate. A currency is regarded as liquid if it may be bought and sold with little variation in the exchange rate.

The market is favoured by traders due to the convenience of trading made possible by forex liquidity. But for the sake of liquidity, some forex market variations must be taken into account.

Not every pair of currencies is liquid. In actuality, the liquidity of currencies varies depending on whether they are major, minor, or exotic pairs (including currencies from emerging markets). As traders go from main pairs to minor pairs, then to exotic pairs, forex liquidity decreases.

A currency pair with high liquidity in the forex market can be purchased or sold in considerable amounts without experiencing major changes in its exchange rate (price level), for example. High liquidity major currency pairs include EUR/USD, GBP/USD, USD/JPY, EUR/GBP, AUD/USD, USD/CAD, USD/CHF, and NZD/USD.

A currency pair with low liquidity in the forex market is one that cannot be bought or sold in sizable amounts without causing major fluctuations in its exchange rate price level. Exotic currency pairs with minimal liquidity include PLN/JPY.

What Causes Liquidity in Forex trading?

Expansion in a monetary policy

The foreign exchange rate, and by extension, liquidity, reacts to shifts in global monetary policy. When a government decides to loosen monetary policy, more money circulates inside the country, raising wages and consumer expectations. The result is a lower exchange rate as the home currency gets devalued.

Increase in global credit supply

Currency market liquidity improves when there is more lending and borrowing available to the general public around the world. When more people have access to credit, they are better able to participate in the Forex market by boosting its liquidity through the purchase of currency pairs.

Decrease in global credit demand

When the demand for credit around the world drops, it usually signifies that consumers and businesses have more than enough cash on hand to meet their financial obligations. As a result, people can invest in the forex market without taking on any more debt.

That’s why greater Forex market liquidity follows a worldwide decline in credit demand. However, if credit demand rises globally, it could mean that investors do not have access to sufficient funds, leading to reduced liquidity in the foreign exchange market.

Liquidity vs Illiquidity

Since the amount of money being exchanged hands at any given time might vary substantially, traders operating in an illiquid market can expect erratic price swings and gaps. Smooth price action is characteristic of a very liquid market, which is also known as a deep market. Because it is difficult to manage risk if you are on the wrong side of a major move in an illiquid market, most traders need and should require a liquid market.

Here are three signs to look out for:

• The forex liquidity indicator

To help traders assess the depth of the market, several brokers include a volume indicator on the price chart. Analysis of the volume chart’s bars provides insight into this forex liquidity indicator. The trader is provided with a reasonable approximation of liquidity by the volume bars, which correspond to the volume traded during the indicated time period. Keep in mind that the liquidity of the foreign exchange market is not reflected by the statistics provided by most brokers but rather by the liquidity of the broker itself. The retail market may be accurately represented by a broker’s liquidity, although this depends on the broker’s size.

• Gaps when trading forex

The forex market has wider spreads than other markets. However, if an interest rate announcement or other piece of high-impact news comes out contrary to expectations, it could cause a price gap in the foreign exchange market. The US market often opens with gaps on Sunday afternoon. Overall gaps in forex are often smaller than a 0.50% of a currency’s value if there is a news announcement over the weekend.

The continuous nature of the forex market means that transaction occurs around the clock, reducing the likelihood of gaps in pricing. Traders can now freely enter and leave the market as they see fit. Since price can spike at the open if overnight news comes out against the crowd’s expectations, a market that only trades for a fraction of the day, like the US Equity market or Futures Exchange, would be condensed into a thinner market.

• Different time of day offer varying amount of liquidity

Forex liquidity changes during the trading day, and day traders and scalpers should be aware of these shifts. Support and resistance levels are more likely to hold from a speculating perspective during less active hours like the Asian Session, which is generally range bound. There are more breakouts and larger percentile moves during the day during the key moving market periods like the London session and the US session.

The US Morning Session is when most of the day’s trading activity takes place because it coincides with the European / London Session, which is responsible for more than half of the world’s daily volume. The US session alone accounts for roughly 20%, and strong moves often slow significantly in the US afternoon, save for the rare occasions when the Federal Open Market Committee makes an unexpected statement.

Forex Market Liquidity impact on trading

Price Stability

By lowering the risk of abrupt and significant price movements, liquidity in the forex market helps to stabilise prices. A liquid market can accommodate big orders without significantly disrupting prices, giving traders more precise pricing information. This steadiness lowers the danger of slippage in erratic market situations and enables traders to make wise selections.

Market Depth

Market depth, which represents the quantity of orders available at various price levels, reflects liquidity. A deep market suggests plenty of liquidity, giving traders more freedom in how they carry out their trades. Trading at preferred price levels gives traders access to competitive pricing and fewer order rejections while they do so.

Execute trades with speed and efficiency

Finding trading partners is less of a challenge during times of high liquidity because there are more potential counterparties to choose from. So, you can enter and leave positions rapidly, without worrying about missing out on promising possibilities. Gain access to better trading terms: Increased liquidity leads to fiercer rivalry among market makers, who in turn provide the lowest possible pricing for buyers and sellers. As a result, you improve your chances of making profitable trades and maximising your returns.

Low Liquidity

Low liquidity levels in the market can make trading difficult and dangerous. When there are fewer buyers and sellers available, it can be more challenging to find willing counterparties for your deals. As a result, bid-ask spreads may widen, leading to more slippage and possibly affecting your trading results.

Minimize slippage

When liquidity levels are healthy, there is less of a chance that a trade will be executed at a price different from the one anticipated. When there are more buyers and sellers in the market, the process of making a trade goes more smoothly and there are fewer price fluctuations.