What is Forex Liquidity
Hello friends Forex traders! We all heard the expression "Forex - the most liquid market." What does it mean? What is liquidity? What are the dangers of low liquidity? What about liquidity inside your broker?
In this lesson we will analyze all these questions in more detail 🙂
The presence of liquidity in the financial markets has many advantages. If the advantages of liquidity are not obvious to you, it is worth asking the opinion of any person who tried to sell real estate during the 2008 crisis, or a trader who had an open position in the wrong direction during the non-trading period before the release of important news, which ultimately led to a reversal of the trend. These people found themselves in a situation where they were not able to exit the deal when they want, and where they want - all because of low market liquidity.
What is liquidity?
Liquidity is the ability to liquidate an asset quickly and without a major change in price. Those. the presence of a high level of supply and demand.
Imagine you have an iPhone and you need to sell it. Because Iphone is an extremely popular phone, it is very easy to sell it. And, pay attention, for this it will not be necessary to significantly reduce the price (given that it is BU of course). He will be taken away from you quickly anyway. Thus, we conclude that Iphone is a liquid product: it is easy to buy and easy to sell, because There are many sellers and many buyers.
Now imagine that you have an old grandmother’s wardrobe, with peeling paint, creaky doors and cracks from time to time. Will it be easy for you to sell it? Unlikely. Most likely you will have to lower the price significantly. Is Grandma’s closet a liquid commodity? Definitely not. There are sellers, but buyers are much less. Yes, and the price will have to be reduced. There is a lack of liquidity in the “Grandmother’s Market” 🙂
Let's get back to the foreign exchange market.
First of all, liquidity reflects the interest of market players - both in the absolute number of traders and in the total trading volumes per unit time. In other words, the presence of a large volume of supply and demand is characteristic of a highly liquid market. The higher the market liquidity, the faster you can eliminate a large position.
From the perspective of an ordinary trader, liquidity is often expressed as a change in volatility. The price in the highly liquid market is moving gradually, in small steps, and quotes are more consistent. EURUSD is one of the most liquid currency pairs; accordingly, on the chart we see an almost perfectly smooth price movement, despite the small timeframe.
The most liquid currency pairs include: GBPUSD, USDJPY, USDCAD, USDCHF, AUDUSD, NZDUSD, GBPJPY and EURJPY.
A decrease in liquidity will lead to large jumps and gaps in the flow of quotes. The volume of applications for the purchase and sale in such a period can vary many times, while remaining small in absolute terms. That is, a situation may occur when the instrument continues to depreciate, but there is no way to sell it completely.
Forex is often mentioned in the context of the most liquid financial market in principle. But this does not mean that currencies are not at all susceptible to the influence of liquidity, and even forex traders need to take this factor into account. Otherwise, for people moving here from other markets, the high Forex liquidity often comes as a pleasant surprise. According to approximate estimates, the daily turnover on Forex is about 4 trillion US dollars.
International trade constantly needs to exchange large amounts of currencies - this is the reason for such a high turnover. It is not surprising that money is the most liquid asset, as it can be immediately exchanged for goods, services and other benefits. Of all currencies, the dollar is currently the most sought after. To begin with, the dollar is at least 1/2 of any major pair, and 75% of Forex transactions fall on the main pairs. The dollar is definitely worth reckoning with.
Liquidity and Volatility
High liquidity does not mean high volatility. The market can be both liquid and weakly volatile.
As we mentioned above, a liquid market moves more smoothly, but low liquidity means more random movements, more chaos. One of the reasons why during the release of important news there are sharp emissions in both directions - the absence at this time of the market of liquidity providers who simply do not want to take risks, blocking transactions on the news.
In general, liquidity can be represented as a buffer that absorbs weak price emissions:
Liquidity at different times
Forex liquidity changes during the trading day, which is associated with the opening of major financial centers in different time zones. As you know, reduced liquidity is observed during the Asian session. However, Japan’s financial reports and comments from local officials may provoke a fairly strong market response simply because less power will counteract the directional movement of the changing mood.
In turn, peak liquidity is observed at the opening of European markets, and in particular London. The activity of players gradually grows throughout the day, until the entry into the game of the markets of North America. By the end of European trading, liquidity sharply sags, and is on the decline from the second half of the American session, until the close of New York.
As already noted, in a period of low liquidity, the market is more vulnerable to unexpected and highly volatile price movements. The catalyst, again, can be news or rumors, which often leads to sharp jumps in quotes and gaps. It is extremely difficult to predict the price movement in such periods; accordingly, trading risks are also overstated. During a low-liquid market, you should always be prepared for an unexpected increase in volatility if you have open positions.
Liquidity can also weaken markedly due to holidays and seasonal activity changes. For example, trading activity falls by the end of summer and before the New Year holidays. As a rule, in such "festive" trading sessions, the market continues to move by inertia, without going beyond the boundaries of a predefined channel.
The situation when a small number of participants remains on the market is called the “thin market”. Large players can use these “weak points” to force movement in the direction of the main key levels. In other words, the less liquidity, the easier the market to “move”. It is not a rare situation when, after such stagnation, the market completely changes its direction to the completely opposite.
Surely, you noticed that at night the time for closing a position can be very different from the daytime, while the market is often in a flat state, in fact, it stands still. If you are trading on a night flat, always keep an economic calendar handy or set up automatic alerts. An hour before the major news release, we remove all positions from the market, so you can save your deposit from the actions of large players.
Broker's Liquidity and Poor Liquidity Dangers
One of the main advantages of Forex is the ability to quickly exchange. But, having a large amount of currency in hand, you cannot quickly sell it during a period of low trading liquidity, without losing much on trade costs. Also, with a lack of liquidity in the market, gaps often arise. A gap is good only when it occurs in your direction. According to the laws of injustice, after a break, the position usually goes into a deep minus.
If a very small number of people are interested in buying foreign currency, liquidity falls. In this regard, trading conditions are deteriorating. In particular, the spread is expanding, the difference between the best purchase and sale prices, and a glass of applications is emptying. With high liquidity, the spread, on the contrary, narrows. Provided, of course, that you have a type of account with market execution.
The liquidity of an individual broker depends heavily on the number of suppliers connected. The more counterparties, the more volume they can process. In addition, a large number of orders positively affects spreads and speed of execution - the more orders we aggregate, the better prices we can get in the end. See details in the material How Forex orders are executed.
Large positions in the highly liquid market are executed exactly at the stated price. When there is sufficient volume at the nearest price, the transaction is executed without slippage.
When there are not enough volumes for the closest applications, the order is partially filled by each of the applications, and the opening price is calculated as a weighted average. That is, the position is partially executed at 0.76237, 0.76238 and 0.76239, after which 0.76239 becomes the new best price.
In any case, no one is protected from sudden surges in volatility. Therefore, do not trust, at first glance, a calm, low-liquid market - appearance can be deceiving. High liquidity has many more advantages, making the market more suitable for technical analysis. A highly liquid market is also a strong market, where the forces are approximately equal on both sides, and one major player is not able to significantly influence the price movement.
Remember this and profit will be on your side.