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.
Pros and Cons of Forex Market Liquidity
PROS
No need to take on high-cost debt
No need for the forced sale of assets in order to raise cash
CONS
Loss of buying power over longer periods of time as returns trail inflation
Conclusion
If you want to make money trading in foreign currencies, you need to have a deep understanding of the Forex market and how it works. When first getting started in Forex, it's recommended that you put your money into highly liquid, low-volatility currencies. If you want to make money trading the Forex market, you need to understand the factors that affect the market's volatility and liquidity on a regular basis and respond accordingly.
It's a common misconception that only "seasoned traders" with lots of money and lots of trades need to worry about liquidity. Liquidity is crucial for experts, but even amateurs should be aware of it. Exotic currency combinations are riskier and less liquid than trading with major currencies like the euro, US dollar, Japanese yen, and others. You should put your money into highly liquid currencies at the outset of your trading career if you want to see a rapid increase in your trading volume.
