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Liquidity is one of the core elements of every financial market, including the forex market. But what exactly is liquidity, and why does it matter to forex traders?
Liquidity is a concept that is fundamental to financial markets. It represents the degree to which an asset can be bought or sold without significantly affecting its price. To understand liquidity, it's important to consider depth. A market with significant depth has many buyers and sellers across many price points that can absorb large orders.
In the foreign exchange market, also called the forex or FX market, liquidity applies similarly; it refers to how easily a currency pair can be bought or sold in real time without impacting its exchange rate. A highly liquid forex market allows traders to open and close positions at their preferred prices, which can help to reduce transaction costs for traders.
Forex is the world’s largest financial market, recording an average of $7.5 trillion in daily volume (Bank for International Settlements). This is down to the large number of participants trading at all hours of the day across different time zones, meaning there's almost always someone willing to buy or sell a currency pair.
The liquidity of a currency pair hinges on its popularity and volume in the market. The most liquid pairs typically involve the world's major currencies, including the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), and the Swiss franc (CHF). For example, the US dollar accounted for 88.5% of daily forex volume in 2022, meaning that pairs featuring the US dollar are often highly liquid.
Forex liquidity is essential to properly functioning markets and entire economies, producing favourable trading conditions and economic stability.
Highly liquid markets generally offer tight spreads, meaning that trades can be executed with minimal costs and closer to the trader’s preferred entry price. For traders executing frequent positions, the effects of transaction costs on their overall profitability are reduced. For institutions trading large quantities at a time, high liquidity enables them to execute large orders without drastically affecting exchange rates.
As for economic stability, excessive currency fluctuations can devastate an economy, deterring investors and affecting the price equilibrium of its goods and services. High liquidity contributes to overall market stability, allowing for smooth price changes and more predictable movements.
Several market participants fuel FX liquidity, from central banks to individual retail traders. Let’s take a closer look at some of them.
Central Banks:
Arguably the most influential participants in the forex market are central banks, who set monetary policy and maintain currency stability for their respective countries. While they may not play as much of an active role as other participants, their actions, including setting interest rates or intervening in currency markets, can significantly affect the liquidity of a currency pair.
Commercial banks could be considered the backbone of the forex market. They typically engage in currency trading as part of their regular banking operations, including international transactions, client hedging, and proprietary trading.
Hedge funds, pension funds, mutual funds, and other financial institutions carry out substantial forex transactions as part of their investment strategies. These entities often make high-volume trades, which adds to FX liquidity.
These companies operate across multiple countries and usually deal with various currencies. Their need to hedge against currency risk can result in large forex transactions, adding further liquidity to the market.
Although individual retail traders account for about 2.5% of daily forex volume (Bank for International Settlements), they still contribute to the overall liquidity.
Liquidity in the forex market can fluctuate, presenting periods of high and low liquidity, each with distinct characteristics and implications for trading.
High market liquidity is characterised by many buyers and sellers, resulting in high trading volumes. During these periods, the spread between the bid and ask prices tends to narrow, reducing slippage and transaction costs.
High liquidity also promotes price stability, helping prices to move in smaller, more predictable increments. These can be optimal market conditions for traders. Major currency pairs, like EUR/USD, GBP/USD, and USD/JPY, often have high liquidity due to widespread acceptance.
In contrast, periods of illiquidity are marked by fewer active traders and a lower trading volume. This environment often leads to wider bid-ask spreads, translating to higher transaction costs for traders.
Moreover, price movements can exhibit more volatility and be less predictable, leading to slippage and price gaps. Lower liquidity is often associated with exotic currency pairs, such as USD/ZAR (US dollar/South African rand) or EUR/TRY (euro/Turkish lira), representing smaller or emerging economies.
Gauging liquidity in the forex market can be difficult, mainly because there isn't a single exchange where all transactions occur. Nevertheless, traders often use several indicators to assess the relative liquidity of a currency pair.
Liquidity in the forex market can be influenced by several factors. These variables can change the trading volume and, consequently, the liquidity of specific currency pairs. It’s worth noting that these factors can lead to illiquidity in even the most liquid of currency markets, like EUR/USD.
The forex market operates 24 hours a day, five days a week, across different time zones. However, liquidity doesn't remain constant during these hours. It tends to be highest during the overlap of major market sessions - the London and New York sessions, in particular. Conversely, during off-peak hours, such as the late US session or the early Asian session, liquidity can be relatively low.
Economic news and events can have a significant impact on forex liquidity. In the moments leading up to and just after high-impact economic releases, like employment reports, inflation data, or central bank announcements, liquidity often dries up as traders wait for the outcome. However, trading volume can rise substantially afterwards, leading to greater liquidity.
In times of high market uncertainty or volatility, like during geopolitical crises or economic shocks, traders may be hesitant to take positions. This can lead to reduced trading volumes and lower liquidity. On the other hand, positive market sentiment, where traders are confident and willing to trade, can boost market activity and liquidity.
Using our knowledge of how liquidity works in the forex market, we can start to pinpoint some of the warning signs of illiquidity that might suggest it’s worth avoiding a position until liquidity picks back up.
Understanding and effectively using liquidity in the forex market can offer some significant advantages, particularly for beginners.
As discussed, trading activity and liquidity tend to peak during the overlap of trading sessions, especially the London and New York sessions. By trading during the busiest times of the day, traders can benefit from tighter spreads and reduced slippage.
In the context of liquidity, different currency pairs suit different trading strategies. Major pairs, like EUR/USD or USD/JPY, are generally more liquid than minor or exotic pairs, meaning they’re best suited to short-term traders. Swing or position traders may be less concerned with liquidity risks since they trade less frequently.
In less liquid markets, erratic price movements can easily trigger a trader’s stop loss. It also affects their take-profit target, as a wider spread means positions are closed at less-than-optimal prices.
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