1 place in the rating! Free trading training!
“Liquidity” is one of the terminologies traders frequently hear about when they engage in financial markets. Of which, forex is considered the most liquid market in the world. Understanding the term “liquidity” will help traders make a careful analysis of the price movement and then a wiser decision on trading foreign currencies.
The Definition of Liquidity in Forex Trading
Liquidity is generally a common term in the financial world. It measures how easily a financial asset is bought and sold at a stable price. In other words, liquidity refers to the ability to quickly convert an instrument into cash. For example, if a tangible asset is priced at $100 and then promptly turned into $100 of cash or cash equivalent, it is called a liquid asset.
Similarly, liquidity in the forex market describes the extent to which one currency is traded in a significant volume without profound influences on its exchange rate. Thereby, currencies that have higher liquidity would be transacted more easily. That is, the liquid market can facilitate transaction flows and render the price of currency pairs more competitive. For instance, you plan to open a 100,000-unit position of EUR/USD at a bid price of 1.21075. If there are many sellers available offering enough amounts at that price or similar prices, possibly 1.21077, so EUR/USD is seen as a liquid currency pair.
Meanwhile, low liquidity implies that the market is less active. This means not so many buyers or sellers jump into trading some currency pairs, especially exotics, which therefore leads to smaller trading volume on the market. Assume you long 100,000 USD/MXN at 19.91044, but it is hard to find a seller that can provide you with that expected quantity. Therefore, you have to buy from different sellers with a wide range of prices and stay in the market for a long time to wait for the order to be filled. Accordingly, when USD/MXN is traded in significant volume, there will be major changes in its exchange rate. This makes the pair less liquid.
Liquidity and Volatility
Another essential factor associated with liquidity is volatility. In general, volatility measures how dramatically the price changes. In both given examples, the price of EUR/USD does not vary too much when this major pair is traded in considerable volume, so it is known to have a low volatility level. Meanwhile, USD/MXN shows the opposite.
In conclusion, liquidity is inversely proportional to volatility. The more liquid a financial asset is, the less volatile it is.
Liquidity Providers in Forex Trading
By definition, a liquidity provider – commonly known as a market maker – is primarily an institution that quotes bid and ask prices in currency pairs with the expectation of making money from spreads which are the difference between the buy and sell price of pairs.
Tier-1 liquidity providers in forex are always large commercial banks, followed by hedge funds and investment management companies. Apart from the role of market makers, those institutions participate in forex trading on behalf of themselves and their clients, contributing the majority of the daily trading volume. Therefore, sometimes forex is implicitly known as the interbank market. It should be noted that central banks often try to avoid intervening in the forex market although their monetary policies profoundly influence the exchange rates of currency pairs. They only step into the market when the price moves in a direction that causes economic harm.
1 place in the rating! Free trading training!
However, in recent decades, the forex market is highly fragmented, hence involving forex brokerage companies and retail traders in selling and buying foreign currencies. Except for NDD (No Dealing Desk) brokers that directly forward orders of investors to liquidity providers, other forex brokers now function as dealers or market makers. Their main source of income comes from spreads, commission fees, and other services.
Factors Behind Liquidity in Forex
Liquidity is determined by the number of active traders and the trading volume of currency pairs. Therefore, any events that affect these two factors can render the forex market liquid or illiquid.
The first impact on liquidity comes from trading times. Forex is the most liquid market because it operates 24 hours a day, except weekends and holidays. Particularly, foreign exchange activities are performed in different sessions that take place in Asia, Europe and North America. Of which, the largest trading volume is recorded from 1 PM to 4 PM GMT+0 when London and New York sessions overlap. This is because the US dollar, euro or such eurozone-related currencies as the Swiss franc (CHF) or British pound (GBP) are on one side of the majority of transactions.
Over weekends and holidays (e.g. Christmas or Easter), the absence of major participants, typically banks, leads to the lack of liquidity. Therefore, to avoid relevant risks, trading platforms provided by forex brokers are closed as well and retail investors cannot enter the market. Having said that, foreign exchange activities still take place. Particularly, banks and financial companies can assign their institutional investors to enter the trade when they realize any signals or news from the market. Also, bureaux de change at airports or in cities can make transactions with travelers.
In such less liquid periods, incurred risks can lead to sudden breakouts and even price movement reversals as the worst cases. Accordingly, traders can experience a new market trend.
Secondly, in normal market conditions, major currency pairs are more liquid and less volatile than crosses (or minors) and exotics. Being formed by top eight currencies that are associated with strong economies and political stability, majors attract much more participants with a large trading volume. However, the liquidity of currency pairs still depends on trading sessions. That is, if you plan to trade EUR/USD, the best time is when London and New York sessions cross; meanwhile, USD/JPY is most liquid when the North America and Asia trading sessions overlap.
Majors are not always liquid in all cases. When any major news that involves economic indicators, changes in policies, trade wars and so forth can abruptly change supply and demand for currency pairs, then making the market more volatile. Typically, after the news came out that Greece and some European countries hid their real debt levels by using accounting practices that did not conform to rules by the Stability and Growth Pact of the European Union, this led to the weakening of the euro against the US dollar. In other words, this European debt crisis in 2010 increased the volatility of the EUR/USD pair.
The Importance of Liquidity in Forex Trading
Liquidity plays an important role in the forex market for some reasons, but mostly because it affects your decision of opening and closing a position. Normally, a liquid market gives speculators confidence in trading foreign currencies without much monetary risk. Accordingly, there is usually someone becoming the counterparty of a certain position, even when a trader buys or sells a significant volume. As a result, there are only small increments in an exchange rate and the trader does not wait so long to close the transaction.
Inevitably, when trading liquid assets, investors can observe smooth moves in price action. Purchasers will not have to pay higher for their expected assets and conversely, sellers can quickly find buyers without reducing the price of currency pairs to make them more attractive. Besides, the high liquidity of pairs also shortens the gap between the price that buyers are willing to pay for and the one that sellers accept. Therefore, bid-ask spreads of more liquid assets will tighten.
An illiquid market will see chaotic moves and large increments in prices. So it would pose forex investors higher risks. Further, spreads of less liquid currency pairs will widen. This means speculators will be charged a higher transaction cost.
From those mentioned analyses, a liquid market is safer to trade on because it is rather challenging to manage risks induced by large market movements. However, in the forex market, risks go favorably with rewards. When opening a position with a liquid currency pair, a trader will face lower risks but concurrently receive smaller profits in case the market moves in his or her favor. So choosing less volatile assets is a safe option for beginners.
Meanwhile, professional traders or institutional investors can exploit the volatility of the market to achieve greater benefits. This explains that the illiquidity of currency pairs is not always a negative sign for investors.
Understanding liquidity and such relevant terminologies as volatility and spreads can facilitate your decisions of entering and exiting trades. Usually, novice investors are advised to start with one major and one minor unless they want to face bigger monetary risks and higher spreads. On the contrary, highly volatile currency pairs like exotics can benefit experienced traders.
However, as already mentioned, liquidity and volatility of currency pairs are affected by various factors, especially plenty of data that change the supply and demand for financial assets. Therefore, wise investors often look at data to decide whether they should jump into the market at that time, even when the market is more volatile.
1 place in the rating! Free trading training!