– Revised by James Stanley, November 24, 2021
As a trader starting out in forex trading, one of the first advantages they are likely to find is how much liquidity the forex market offers over other markets. The latest figures are about $ 5.1 trillion in daily trading volume according to the 2016 International Settlements Bank’s three-year report.
Forex liquidity allows ease of trading, making the market popular among traders. However, some variations in the FX market need to be considered for liquidity purposes. This article will explain the concept of forex liquidity as well as liquidity risk, ultimately seeking to provide a general understanding of how liquidity affects trading.
What is liquidity and why does it matter?
Liquidity in the forex market is by definition, the ability of a currency pair to be traded (bought / sold) on demand. When you trade major currency pairs, you are trading a market that is extremely liquid. However, you trade on the basis of the available liquidity of financial institutions that enter or exit the trade (currency pair) of your choice.
Not all currency pairs are liquid. In fact, currencies tend to have varying levels of liquidity depending on whether they are important, unimportant and exotic pairs (including emerging market currencies). Forex liquidity dries up during a trader’s move from major pairs to small pairs and ultimately to the exotic pairs.
High liquidity in forex refers to a currency pair that can you are bought / sold in significant sizes without large variations in its exchange rate (price level) – e.g. Important currency pairs such as EUR / USD.
Other important currencies (very liquid) pairs to be aware:
Low liquidity in forex refers to a currency pair that can’t to be bought / sold in significant sizes without large variations in its exchange rate price – e.g. exotic currency pairs like PLN / JPY.
Forex liquidity vs illiquidity: 3 Signs to watch out for
From a trader’s point of view, a liquid market will have chaotic shifts or gaps because the level of buying or selling volume at some point can vary greatly. A highly liquid market is also known as a deep market or a smooth market and price action is also smooth. Most traders need and should demand a liquid market because it is very difficult manage risk if you are on the wrong side of a big move in a liquid market.
Here are three signs to watch out for:
1. GAPS WHEN TRADING FOREX
Shortcomings in forex vary compared to other markets. However, price gaps can occur in forex if interest rate announcement or other high effective news announcement goes against expectations.
Shortages may occur at the weekly opening on Sunday afternoon in the United States. If there is a news announcement over the weekend, then general gaps in forex are usually less than 0.50% of the value of a currency.
The charts below show the difference in liquidity between the stock market and the forex market, as highlighted by gapping.
Stock markets are prone to shortages: FTSE 100 index
Forex market shows little / no gap:
A market that trades 24 hours a day as the forex market is consideredmore liquid or simply tends to have fewer gaps due to the continuous naturein the stock market. This allows traders to enter and exit the market at their discretion. A market that trades only for a fraction of the day, such as the U.S. Stock Market or Futures Exchange, would be condensed into a thinner market because price can jump to the open if overnight news appears against the expectations of the crowd.
2. THE FOREX LIQUIDITY INDICATION
Brokers often offer a “volume” option on the chart by which a trader can assess the liquidity of the market. This forex liquidity indicator is interpreted by analyzing the bars on the volume chart.
Each volume bar represents the volume traded during the specified time period, thus giving the trader an appropriate approximation of liquidity. It is important to remember that most brokers only reflect their own liquidity data and not the overall forex market liquidity. However, using a broker’s liquidity as a gauge can represent the retail market properly depending on the size of the broker.
3. DIFFERENT TIMES OF THE DAY OFFER VARIOUS TUB QUOTE
Short-term traders or scalpers should be aware of how liquidity in forex varies through the business day. There are less active hours like the Asia Session that is often interspersed meaning support and resistance levels are more likely to hold from a speculative point of view. The main moving market sessions such as the London session and US session are more prone to explosions and larger percentage moves in the day.
The time of day when you are likely to see the biggest moves is the American Morning Session because it coincides with the European / London Session which alone accounts for approximately + 50% of total daily global volume. The US session alone occupies about 20% and in the US Afternoon, you will often see a sharp drop in aggressive moves except when the Federal Open Market Committee (FOMC) comes out with a surprise announcement that is only a few times a year.
Liquidity Risk vs. Reward
The relationship between risk and reward in financial markets is almost always proportional, so understanding the risks involved in trading must be considered.
A major example of liquidity risk in the forex market is the Swiss franc crisis in 2015. The Swiss cinternal bank announced they would no longer be conservative the Swiss franc peg against the Euro causing the interbank market to become broken due to an inability to price the market. This led to brokers not able to offer liquidity on CHF. As interbank prices (the backbone of forex prices) returned, EUR/CHF prices were far from the previous range. This caused retail account salts for those trading CHF to be largely affected. While these “Black Swan” events are rare, they are not impossible.
Retail forex traders need to manage these liquidity risks or lowering theirs leverage or use of guaranteed stops by which the broker is obliged to honor yours stop price level.
Weighing the choices between liquidity risk and reward should not be overlooked and should be included as part of a trader’s analytical routine.
Further reading to take your forex trading to the next level
- The forex market has evolved over the centuries. For a summary account of the major developments shaping this $ 5 trillion daily market, read more about the forex history.
- Our research team analyzed more than 30 million live businesses to discover the traits of successful marketers. Incorporate these features to give you an edge in the markets.
- Traders often look to retail customer sentiment when trading popular FX markets. DailyFX provides such data, based on IG customer feel.
- If you are just starting your business journey, it is essential to understand the basics. Download ours for free New to Forex business guide.