The Significance of Liquidity in Forex Trading

The Significance of Liquidity in Forex Trading

Reading time: 15 minutes

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.

What Is Liquidity in the Forex Market?

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.

The Importance of Liquidity in the Forex Market

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.

Market Participants That Influence Forex Liquidity

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:

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.

Institutional Investors:

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.

Multinational Corporations:

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.

Retail Traders:

Although individual retail traders account for about 2.5% of daily forex volume (Bank for International Settlements), they still contribute to the overall liquidity.

How to Identify High Liquidity and Low Liquidity

Liquidity in the forex market can fluctuate, presenting periods of high and low liquidity, each with distinct characteristics and implications for trading.

High Liquidity:

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.

Low Liquidity:

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.

Measuring Forex Liquidity

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.

• Bid-Ask Spread: The bid-ask spread is a direct indicator of liquidity. A narrow spread indicates high liquidity, while a wide spread suggests lower liquidity.
• Volume: Generally speaking, strong trading volumes suggest high liquidity, while low volumes indicate less liquidity. However, given the FX market’s decentralised nature, accurate volume data can be hard to obtain. As such, it’s best to compare a pair’s volume with its historical volume to gauge relative liquidity rather than comparing two separate pairs.
• Price Movement: Liquidity is also reflected in price movements. In liquid markets, prices change smoothly without abrupt gaps or extreme spikes, while illiquid markets are often volatile and frequently produce gaps.
• Market Depth: The depth of the order book, available through some trading platforms, can provide insights into market liquidity. A deep order book with many buy and sell orders at different price levels indicates high liquidity.

Factors That Influence Liquidity

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.

Market Hours:

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:

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.

Market Sentiment:

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.

Warning Signs of Illiquidity

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.

• Widening Spreads: One of the most apparent signs of illiquidity is a widening bid-ask spread. You’ll often notice wide spreads toward the end of trading sessions or just before an important economic release.
• Increased Slippage: Slippage occurs when a trade is executed at a different price than expected. If you notice your orders are continually being filled at less-than-favourable prices, then you may be trading an illiquid market.
• Price Gaps: Price gaps – where the price of a currency pair jumps from one level to another without trading at prices in between – are more likely to occur in illiquid markets. This is because the lack of buyers or sellers at certain price levels can cause prices to move sharply until an order can be filled.
• Higher Volatility: Illiquid markets can be subject to larger price swings, even in response to relatively small trades. If you notice erratic and substantial price movements without a corresponding change in fundamental factors, it could indicate a lack of liquidity.
• Decreased Market Depth: A shallow order book, characterised by fewer buy and sell orders at different price levels, can signal illiquidity. This may be more noticeable in less popular or exotic currency pairs.

Working with Liquidity in Forex Trading

Understanding and effectively using liquidity in the forex market can offer some significant advantages, particularly for beginners.

Choosing the Right Trading Times:

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.

Selecting Appropriate Pairs:

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.

Risk Management:

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.

Forex Liquidity: Risks and Rewards

Rewards of High Liquidity:

• Tight Spreads: High liquidity often translates into tighter spreads, lowering transaction costs.
• Price Stability: Liquid markets tend to produce less drastic price swings, making price action easier to read.
• Easy Execution: In liquid markets, orders are more likely to be filled at the desired price, which is essential when trading large volumes.

Risks of Low Liquidity:

• Increased Costs: In illiquid markets with wide spreads, increased transaction costs may make certain short-term strategies unviable.
• Volatility: The added volatility of illiquid markets can increase the risk of losses without strong risk management practices.
• Slippage: Low liquidity can increase the risk of an order being filled at a worse price than expected, reducing profitability and potentially amplifying losses.