Importance Of Liquidity And Its Applications In Forex Trading

Last Updated September 1st 2021
9 Min Read

Liquidity is an important factor for a financial market. No matter how wealthy you and your country are, you may lose all your money if you do not have enough liquidity or liquid assets. You must have heard about the lack of liquidity in the market during financial crises. Many companies also declare themselves bankrupt when they do not liquid assets to pay off their clients.

Like all other financial markets, liquidity is a key factor for forex trading. The forex market offers very high liquidity over other markets. Forex traders also take advantage of this liquidity as and when they start. Forex liquidity allows a trader to trade easily and make forex a popular market.

This article will explain to you the importance of liquidity and an overall view of how liquidity affects forex trading.

What Is Liquidity?

Liquidity refers to the active status of the market. It means how many traders and how much volume is being traded in the market at a particular time. Let’s understand this with an example. When the pandemic started, and all the governments made use of masks mandatory, there was a high demand for masks in the market. As a result, many companies started working on the production of surgical masks. Soon, the demand and supply of the masks were high. People were easily buying and selling masks. That means the surgical masks market was highly liquid.

So, this example shows how much a product was in demand in the market. This is the market liquidity. When the demand and supply of a product and service are higher in the market, you can buy or sell your things in no time. In the financial market, liquidity means how quickly and easily you can convert your financial assets into physical or electronic cash.

Some instruments are quite liquid and can be easily bought and sold in the market, for example, gold or US bonds. On the other hand, some are less liquid. It means that there are no buyers for them in the market for example - Greek bonds. You cannot sell or exchange them for any other instrument in the market. 

What Is Liquidity In The Forex Market?

Liquidity in the forex market refers to the ease with which you can buy or sell a currency pair without creating a major impact on the exchange rate. If for a currency pair, there is a good amount of trading activity, and you can buy and sell them easily, it means that the currency pair is highly liquid. On the other hand, the currency pair with less trading activity will be less liquid. 

The forex market is considered to be one of the most liquid markets when compared to other financial markets. It is mainly because of two reasons. Firstly, you can trade in this market 24 hours a day for seven days. Secondly, the daily turnover of the global foreign exchange market is about $6.6 trillion. At any point of time, there is a high amount of forex trading going on in this market.

Read Also: How to Start Making a Profit With Forex Trading

Importance Of Liquidity In Forex Trading 

If you trade in a liquid currency pair, you will surely get its unsaid benefits. However, if you trade in a currency pair based on its availability in the market, your trade will depend on the liquidity of the financial institution. This liquidity will help you keep in and out of the trade. 

  • Liquidity decides how quickly and easily you can open and close a position.
  • Liquidity reduces risks as buyers and sellers are always available in the market.
  • An asset’s liquidity also determines the spread a trading platform can offer you. In case of high liquidity, the bid-offer spread will become tight. Because the highest price a buyer can pay and the lowest price a seller can accept will become close.
  • High liquidity in the forex market ensures low volatility. This means that there are no drastic fluctuations in prices.

Currency pairs in a forex market have varying levels of liquidity. The liquidity depends on whether a currency pair is a major, minor, or exotic one. As a trader move from major to minor or towards an exotic pair, forex liquidity tends to dry up.

High liquidity in the forex market means that you can purchase and sell your pair in significant sizes without moving the market too much in either direction. However, it will depend on the currency exchange rate and the amount you are trading.

Major currency pairs are highly liquid. Some of them are: 

  • GBP/USD
  • USD/JPY
  • EUR/GBP
  • AUD/USD
  • USD/CAD
  • USD/CHF
  • NZD/USD

Alternatively, low liquidity means that you cannot buy or sell a currency pair in significant sizes without creating an impact on its exchange rate. Exotic currency pairs have very low liquidity such as PLN/JPY. For currency pairs with low liquidity, there are chaotic and random moves in the market. 

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Who Brings Liquidity To The Forex Market?

Any market broker or institution who works as a professional market maker from both ends of a currency transaction is a liquidity broker. Several market participants increase forex liquidity volume

They are:

  • Commercial banks: Banks can act as market makers and speculative traders to provide liquidity.
  • Central banks: Central banks enter into foreign exchange markets to stabilise their country’s currency. They can do forex trading to move their currency reserve holdings. This provides considerable liquidity to the market.
  • Transnational corporations: Companies, which are involved in business with other nations, provide high liquidity to the market. They hedge forex risk and act as customers of large banks.
  • Individual currency speculators: People with a high net worth or the small players who deal with retail forex brokers are also a large group of liquidity providers in the forex market.
  • Foreign investment managers: Companies, which are managing investment in foreign stock or bonds, add liquidity by initiating, closing, or hedging their foreign investment positions.
  • Retail Foreign Exchange Brokers: These brokers have made foreign exchange trading accessible to wider customers. This in turn increases market liquidity substantially.

How A Trader Can Identify Liquidity In The Forex Market?

In an illiquid market, trading volume will vary at any moment of the day. On the other hand, liquid market (also known as deep or smooth market) the price action is smooth. For a forex trader, good liquidity is quite important because you cannot manage risks that come with the illiquid market.

There are certain strategies that traders can use to gauge the liquidity in the forex market. 

The indicators of forex liquidity:

  • Broker Volume: Your trading platform gives you the option of showing “trade volume” on your charts. At the bottom of each price bar data, there is a volume bar that shows how much money was traded during a period. However, this is the volume of the broker’s trade not that of the forex market. However, with this, you can judge the liquidity of the market.
  • Level II trade screen: You can also notice a level II trade screen in your trading account. This shows how much a currency is available at the current price along with the levels higher and lower than that. If you notice that millions of dollars are available for trading in several pips of the current price, it means that there is high liquidity. On the other hand, the availability of only a few thousand dollars for trade indicates high chances of fluctuations. 
  • Time of the day Averages: Every currency is more liquid when the market associated with that currency is open. For example, the EUR/USD currency pair is most liquid when US and European markets are open. If you trade a currency when its market is open, it ensures ample liquidity for trading.
  • Currency pair averages: You must know that few currency pairs always have good liquidity for retail traders. One example is that of EUR/USD. There is significant activity in this currency pair at any time of the week. As a result, you can be sure of high liquidity with these pairs.

Factors That Affect The Liquidity In The Forex Market

Price gaps in the forex

You can trade in a forex market for 24 hours a day. You can easily enter and exit from the forex at any time of the day. Thus, a forex market does not have too many price gaps. Alternatively, the markets, that work only for some hours in a day tend to show price gaps due to some unwanted and unpredicted announcements made overnight.

However, any unexpected news announcement or any change in the interest rate can bring price gaps in forex. The overall gaps in forex are generally less than 0.50% of the value of a currency. Liquidity providers do not want to risk their positions over news releases and thus, do not indulge in trade.  This leads to sharp price hikes in both directions.

Different trading sessions and liquidity

Though the forex market is open 24 hours a day, it does not mean that you will see the same level of liquidity throughout the day. Some times of the day show high liquidity in forex while at other times, it dips. As a short-term trader, you must know when the forex market is most liquid.

Almost all currencies trade in the forex market and thus, it is highly anticipated. The forex market is generally divided into different sessions into different zones based on the start of operations at their financial centres. Every session has its level of liquidity.

The most active and high liquid time of the forex is when the US morning session coincides with London/European session. The London/European session alone contributes around half of the daily globally traded volume. On the other hand, the US session alone accounts for 20% of the globally traded volume. Once the US afternoon session begins, you will see a drop in the trade volume. However, some surprise announcements made by Federal Open Market Committee (FOMC) can prevent these drops in the afternoon. But it is only a few times a year.

Apart from these, the Asian session is less active and less liquid. This is because the support and resistance are directly controlled by speculations

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Holidays and changes in seasonal activity

At the end of the summer or before the New Year holidays, there is a decline in the trading activity.

Thin market

It is the time when only a few buyers and sellers are left in the market. Thus, the price movements are larger than normal. This situation is characterized by high price volatility and low liquidity. Large and experienced forex traders take advantage of these weak points to achieve major key levels. As volume is low, overall transactions are higher making the spreads wider.

Forex Liquidity: Risk or Reward

Though forex liquidity is mostly rewarding, it brings risks as well. The major example of liquidity risk is that of the Swiss Franc crisis that occurred in the year 2015. Thus, as a forex trader, you must know how to manage your liquidity risk. To manage liquidity risk, you can lower your leverage that will reduce your losses but profit also. On the other hand, you can manage this liquidity risk with the use of guaranteed stops. It means you create a stop loss at your order so that your position is closed at a pre-determined price level. Guaranteed stops are generally not affected by market volatility. Always weigh your options between liquidity risk and reward to be in the best position. 

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