When starting out in forex trading, traders quickly realize the significant advantage of the forex market's high liquidity compared to other markets. According to the Bank of International Settlements' triennial report of 2016, the forex market has a daily traded volume of approximately $5.1 trillion.
Forex liquidity refers to the ease with which trades can be executed in the market, which is one of the main reasons why many traders are attracted to it. However, it is important to consider certain factors that can affect liquidity in the forex market. These factors can result in liquidity risk, which is the potential difficulty in buying or selling currencies without causing significant price movements.
This article aims to provide a comprehensive understanding of forex liquidity by explaining the concept itself and highlighting the associated risks. By gaining a thorough understanding of liquidity and its impact on trading, traders can make informed decisions and navigate the forex market more effectively.
HOW DOES LIQUIDITY WORK AND WHAT MAKES IT MATTER?
Liquidity in the forex market refers to the ease with which a particular currency pair can be bought or sold at any given time. When trading major currency pairs, you have the advantage of operating in an extremely liquid market. However, it's important to understand that your ability to trade is reliant on the liquidity provided by financial institutions that facilitate your entry into or exit from a specific currency pair.
Currency pairs in the forex market do not possess equal levels of liquidity. Liquidity varies depending on whether the currency pair is categorized as major, minor, or exotic, which includes emerging market currencies. As traders move from major pairs to minor pairs and eventually to exotic pairs, the liquidity in the market diminishes.
High Liquidity
When we talk about high liquidity in forex, we are referring to currency pairs that can be traded in substantial volumes without significant fluctuations in their exchange rates or prices. Examples of major currency pairs that exhibit high liquidity include EUR/USD, GBP/USD, USD/JPY, EUR/GBP, AUD/USD, USD/CAD, USD/CHF, and NZD/USD.
Low Liquidity
Conversely, low liquidity in forex indicates currency pairs that cannot be traded in significant volumes without causing significant changes in their exchange rates or prices. Exotic currency pairs, such as PLN/JPY, typically fall into this category.
INDICATORS OF FOREX LIQUIDITY AND ILLIQUIDITY: 3 KEY FACTORS TO MONITOR
From the perspective of a trader, when a market lacks liquidity, it experiences erratic and unpredictable fluctuations or gaps due to the significant variations in buying or selling volume at any given time. On the other hand, a highly liquid market, often referred to as a deep or smooth market, displays price movements that are consistent and steady. Traders typically prefer and necessitate a liquid market since it becomes exceedingly difficult to effectively handle risk when confronted with a substantial and sudden market shift in an illiquid environment.
Here are three indicators to be mindful of, which are:
1. GAPS WHEN TRADING FOREX
Gaps in the foreign exchange (forex) market differ from gaps observed in other markets. In the forex market, price gaps can emerge when there is an unexpected interest rate announcement or the release of significant news that deviates from market expectations. Additionally, gaps can occur at the beginning of the trading week on Sunday afternoon in the United States. However, if there is a news announcement during the weekend, the overall occurrence of gaps in the forex market is typically limited to less than a 0.50% deviation from a currency's value.
The following charts illustrate the contrasting liquidity levels between the equity market and the forex market, emphasizing the occurrence of gapping in the latter.
Equity markets, including the FTSE 100 Index, are susceptible to experiencing gaps in price movements.
The forex market is characterized by minimal to no occurrence of price gaps.
A market that operates round the clock, such as the forex market, is generally regarded as more liquid or prone to fewer price gaps compared to markets with limited trading hours, like the US equity market or futures exchange. The continuous nature of forex trading enables traders to engage in buying or selling activities at any time as per their preference. Conversely, markets that have restricted trading hours become relatively thinner due to the condensed trading period. As a result, if unexpected news emerges overnight that contradicts the prevailing market sentiment, price jumps can occur at the market open, leading to potential gaps in such condensed markets.
2. THE FOREX LIQUIDITY INDICATOR
Traders can utilize a "volume" option on their charts, provided by brokers, to assess the liquidity of the forex market. This forex liquidity indicator is interpreted by analyzing the bars displayed on the volume chart.
Each volume bar represents the trading volume during a specific time period, offering traders an approximate measure of liquidity. It's important to note that brokers typically present their own liquidity data, which may not reflect the overall liquidity of the entire forex market. However, by using a broker's liquidity as a reference, traders can gain a suitable understanding of the retail market, taking into account the size of the broker.
3. DIFFERENT TIMES OF DAY OFFER VARYING LIQUIDITY LEVELS
For short-term traders or scalpers, being aware of the fluctuations in forex liquidity throughout the trading day is crucial. Less active hours, such as the Asian Session, often exhibit a range-bound market condition, where support and resistance levels are more likely to hold based on speculation. Conversely, during the major trading sessions like the London session and US session, there is a higher probability of breakouts and larger percentage moves during the day.
The time of day that tends to witness the most significant market movements is the US Morning Session, as it overlaps with the European/London Session, which alone accounts for roughly 50% of the total daily global volume. The US session itself contributes to around 20% of the total volume. In the US Afternoon, aggressive price movements generally taper off, except in cases where the Federal Open Market Committee (FOMC) surprises the market with an announcement, which occurs only a few times a year.
LIQUIDITY RISK AND REWARD
Understanding the relationship between risk and reward is crucial in financial markets. It is generally observed that the higher the risk, the greater the potential reward. Therefore, when engaging in trades, it is essential to consider the risks involved.
An illustrative instance of liquidity risk occurred during the Swiss Franc crisis in 2015 within the forex market. The Swiss central bank's announcement to discontinue preserving the Swiss Franc's peg to the Euro caused significant disruption in the interbank market. This disruption resulted in an inability to accurately price the market, leading to a lack of liquidity for the Swiss Franc. Consequently, brokers were unable to provide sufficient liquidity for trading CHF. When interbank pricing eventually stabilized, EUR/CHF prices deviated significantly from their previous range. As a result, retail traders who had been trading CHF experienced substantial impacts on their account balances. While such unforeseen events, often referred to as "Black Swan" events, are infrequent, they are not impossible.
To effectively manage liquidity risks, retail forex traders have two main options. They can either decrease their leverage or utilize guaranteed stops, which ensure that the broker will honor their specified stop price level.
It is crucial not to overlook the evaluation of the trade-off between liquidity risk and potential reward. This evaluation should be an integral part of a trader's routine analysis.
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