What is liquidity in Forex?
You may have heard that the forex market is the most liquid financial market in the world, with a turnover of over $7 trillion daily. But do you know what liquidity stands for, and can you use this factor to increase profitability from currency trading? In this article, we will understand the concept of liquidity with examples, its types, characteristics, and how to manage it.
Here's a quick look at what you'll read
Liquidity is the ability, extent, or how quickly a financial asset can be bought, sold, or converted into cash in the market.
- High Liquidity
- Low Liquidity
EUR/USD, AUD/USD, GBP/USD, and JPY/USD are some examples of highly liquid pairs. Meanwhile, EUR/TRY, USD/SEK, USD/HKD, and NZD/SGD are some low liquidity pairs.
- Economic reports, data, & financial news
- Trading Instrument
- Market Liquidity Providers
- Time Frame
- Market Sentiments
- Market Gaps & Slippage
- Volatility
- Spread
What is liquidity in Forex?
Liquidity is the ability, extent, or how quickly a financial asset can be bought, sold, or converted into cash in the market.
In the currency market, liquidity deals with how quickly a currency pair can be bought and sold without significantly impacting the exchange rate.
Types of liquidity in Forex
High Liquidity:
When a currency pair is exchanged quickly in the market, it is said to be highly liquid. It is a condition when many buyers and sellers are in the market.
Generally, traders look for highly liquid currency pairs to trade in due to high-profit probability. Fx spreads are also tight for high-liquid pairs. EUR/USD, AUD/USD, GBP/USD, and JPY/USD are the examples of highly liquid pairs.
Low Liquidity:
It is when finding buyers and sellers in the market is difficult. Generally, exotic pairs or pairs of developing or underdeveloped countries offer less liquidity.
As a result, the spreads are broad, and the market conditions are unfavorable. EUR/TRY, USD/SEK, USD/HKD, and NZD/SGD are some low liquidity pairs.
Why is liquidity so important in Forex?
In order to understand the concept and importance of liquidity in forex trading, let us have a look at an example. You may have seen people investing or trading in gold, but do you know why they do so?
Because it is easy to sell gold and convert it into cash, you can quickly sell it and get a higher value. So, it is a highly liquid asset. Now, suppose you have bought a car for $50,000. Will you get the same value or more when you sell it? The answer is no.
It isn’t easy to convert a car into cash. Plus, you will get a low amount. So, basically, it offers less liquidity. The same concept is applied in the currency market.
Some pairs are highly liquid and offer excellent market conditions for traders, while some provide low liquidity and are risky to trade in. Therefore, liquidity is crucial for determining the right currency pair to trade in and directly affects your trading outcome.
What causes Forex liquidity
The changes in the market conditions of a pair cause changes in the liquidity of a pair. So, let us learn about the factors that cause changes in liquidity and their impact.
Fundamental Factors:
Economic reports, data, events, financial news, central bank announcements, government policies, and other fundamentals have a significant impact on the liquidity of a pair.
Therefore, traders wait for such events that cause low liquidity before the release. They place trade after the releases based on the findings, so after the event, liquidity increases.
Suppose that employment data comes positive for the USA. It will positively impact the currency, and people will start buying the currency against the other. As a result, liquidity for the major pairs increases after the release.
Trading Instrument:
In the forex market, there are three types of pairs, including the majors, the minors or crossover, and the exotic. The change in these pairs’ demand and supply impacts Forex’s liquidity.
In addition, as we have discussed above, the liquidity of major and some minor pairs is high due to stable market conditions, while the liquidity of exotic pairs is low. So, the type of financial asset also causes changes in liquidity.
Market Liquidity Providers:
The activities of big commercial banks, Electronic Communication Networks (ECNs), and other major foreign exchange participants who engage and influence the market. Therefore, these participants are also known as market makers as they act as liquidity providers.
Forex brokers’ platforms stay connected with these providers to access liquidity. Therefore, brokers in connection with multiple providers offer good liquidity traders.
Time Frame:
You may have seen traders giving too much importance to forex market hours. Have you wondered why? Because the market conditions vary in each session.
London and European sessions offer significant liquidity, especially during overlap timing. Meanwhile, Asian sessions offer low liquidity due to less activity.
How to measure liquidity in the forex market
A trader can make the trading decision considering the liquidity and make a good profit. Here are some crucial elements that help you determine liquidity in the foreign exchange market.
Market Sentiments:
There are three types of analysis in trading: fundamental, technical, and sentimental. The perception or opinion of the majority of people in the market also affects liquidity.
Suppose on social media platforms, telegram groups, and newspapers, there is a perception that the EUR will weaken against the USD. These sentiments triggered the buyers, and traders will start buying the EUR/USD pairs. That’s how positive and negative market sentiments will impact liquidity. So, market sentiment can be a good indicator to measure liquidity.
Market Gaps & Slippage:
A gap is a condition used for the difference between a candlestick’s closing price and the opening price. These gaps occur during important announcements or significant economic events.
Meanwhile, slippage can be defined as the difference between the expected price and the price at which trade is executed due to changes in market conditions. Generally, gaps and slippage are more frequent during low liquidity periods.
Volatility:
Liquidity and Volatility are interrelated factors that impact each other. Market volatility refers to the degree of price fluctuation over a period of the financial instrument.
Highly volatile assets are more risky and unpredictable, which causes low liquidity. Meanwhile, low-volatility instruments are more stable and predictable, which causes High liquidity.
Spread:
One of the popular elements to find liquidity is to check spreads. Generally, tight spreads indicate high liquidity, predictable market conditions, and easy trade execution.
Meanwhile, wide spreads indicate low liquidity and unpredictable market conditions. So, one can identify liquidity by checking the ask-bid difference during the period.
Conclusion
The concept of liquidity in Forex is quite simple yet helpful. Once you start trading considering liquidity, the trading game will become more enjoyable.
The Knowledge of liquidity will reduce your overall trade cost, eliminate the chances of gaps and slippage, facilitate easy trade execution and stability, and many more trading perks.
Trading is based on prediction, and these predictions are made after studying the market conditions of the financial asset. Even in general life, people buy or sell assets considering liquidity.
The trading game involves risk, so liquidity became more critical, especially for forex traders.
