What may be found on this page?
- WHAT EXACTLY IS MEANT BY THE TERM “LIQUIDITY,” AND WHY IS IT SO VITAL?
- FOREX LIQUIDITY VS ILLIQUIDITY: 3 SIGNS TO LOOK OUT FOR
- LIQUIDITY RISK VS REWARD
The high level of liquidity that the forex market provides compared to other markets is likely to be one of the first benefits a trader encounters when they begin their career in foreign exchange trading, According to the triennial report issued by the Bank of International Settlements in 2016, the most recent estimates place the average daily traded volume at around $5.1 trillion.
The simplicity of trading enabled by forex liquidity contributes to the market’s popularity among traders, However, to provide adequate liquidity, some fluctuations in the foreign exchange market must be considered, This article will explain the notion of forex liquidity and liquidity risk, with the ultimate goal of providing a general grasp of how liquidity impacts trading.
WHAT EXACTLY IS MEANT BY THE TERM “LIQUIDITY,” AND WHY IS IT SO VITAL?
The capacity of a currency pair to be exchanged (bought or sold) on demand is the definition of what is meant by the term “liquidity” in the foreign exchange market, When you trade extensive currency pairings, you are participating in trading a very liquid market, On the other hand, you are trading based on the available liquidity of financial institutions, which gets you into or out of the trade (currency pair) of your choice.
Not all currency pairings are liquid, The degree to which currencies are liquid may vary significantly depending on whether they are significant, minor, or exotic pairings (including currencies used in developing markets), As traders shift their focus from the main pairs to the minor pairs and then to the exotic pairings, the level of liquidity in the foreign exchange market decreases.
A High Level of Liquidity:
When discussing foreign exchange, “high liquidity” refers to a currency pair capable of being purchased and sold in considerable amounts without experiencing significant shifts in its exchange rate (price level), An example would be significant currency pairings like the EUR/USD.
Other important currency pairings that are highly liquid that you should be aware of are as follows:
- GBP/USD
- USD/JPY
- EUR/GBP
- AUD/USD
- USD/CAD
- USD/CHF
- NZD/USD
Insufficient Liquidity:
In the foreign exchange market, the term “low liquidity” refers to a currency pair that cannot be purchased or sold in considerable numbers without causing significant fluctuations in the price level of its exchange rate, One example of this is exotic currency pairings like PLN/JPY.
FOREX LIQUIDITY VS ILLIQUIDITY: 3 SIGNS TO LOOK OUT FOR
An illiquid market will have chaotic movements or gaps from the traders’ perspective since the amount of buying or selling volume at any instant might vary substantially, This is because an illiquid market needs more buyers or sellers, A very liquid market is sometimes referred to as a deep or a smooth market, and the price movement in such a market is likewise smooth, Because it is tough to manage risk if you’re on the wrong side of a massive move in an illiquid market, and most traders need and should demand a liquid market, most traders should require a liquid market.
Here are three warning signals to keep an eye out for, which are as follows:
- GAPS WHEN TRADING FOREX
The gaps in the currency market are different from those in other markets, On the other hand, price gaps may appear in the foreign exchange market if an interest rate announcement or another high-impact news item is released contrary to market expectations.
In the United States, the beginning of the new week often begins on Sunday afternoon, This is when gaps might appear, The overall gaps in the forex market are typically less than 0.50% of a currency’s value whenever there is a news release over the weekend.
The following charts illustrate the disparity in liquidity between the FX market and the equities market, with gapping accentuating this divergence.
The FTSE 100 Index is one example of a market prone to gaps.
The foreign exchange market has little or no gapping:
Due to the continuous nature of the equity market, a market that trades at all hours of the day and night, such as the foreign exchange market, is seen as being more liquid or tends to have fewer gaps, Traders are then free to join and leave the market at their convenience as a result of this, A market that only trades for a portion of the day, such as the US Equity market or the Futures Exchange, would be condensed into a thinner market because prices can spike at the open if overnight news goes out that goes against the crowd’s expectations.
- THE MARKET LIQUIDITY INDICATOR FOR FOREX
A trader may determine the market liquidity level by using an option on the chart labeled “volume.” Brokers often provide this option, An analysis of the bars on the volume chart is required to make sense of this forex liquidity indicator.
The trader is provided with a reasonable estimation of the market’s liquidity, given that each volume bar displays the volume of trades that occurred during the specified period, It is essential to remember that most forex brokers only represent the data pertaining to their liquidity, not the liquidity of the global forex market, However, depending on the broker’s size, using the broker’s liquidity as a barometer may accurately reflect the retail market in some instances.
- DIFFERENT TIMES OF DAY OFFER VARYING AMOUNTS OF LIQUIDITY
Traders that scalp or trade for short periods should be aware of how the liquidity of the forex market changes during the trading day, There are certain less busy hours, such as the Asian Session, which is often range bound, which means that support and resistance levels have a greater chance of being maintained from a speculative point of view, Breakouts and more considerable percentile changes tend to occur more often during the day’s critical moving market sessions, such as the London and US sessions.
Because the US Morning Session overlaps with the European / London Session, which alone accounts for approximately +50% of total daily global volume, the US Morning Session is the time of day during which you are most likely to observe the largest price fluctuations, The US session alone accounts for approximately 20%, and in the US afternoon, aggressive movements typically decline sharply, except for the few times a year when the Federal Open Market Committee (FOMC) makes a surprise announcement.
LIQUIDITY RISK VS REWARD
Understanding the risks associated with a transaction is necessary because the connection between risk and return in the financial markets is usually proportional.
The Swiss Franc crisis in 2015 is a prime illustration of the liquidity risk in the foreign exchange market, The Swiss national bank announced it would no longer maintain the Swiss franc’s peg to the euro, This caused the interbank market to become dysfunctional due to the inability to price the market accurately, As a consequence, brokers could not provide liquidity on CHF After the restoration of interbank pricing, which is the fundamental component of currency pricing, EUR/CHF prices significantly differed from their prior range, Consequently, the balances of retail customer accounts for those trading CHF was significantly impacted, Even though occurrences described as “Black Swans” are uncommon, they can take place.
Retail forex traders have two options for mitigating the risks associated with liquidity: either reduce their leverage or make use of guaranteed stops, in which case the broker is committed to meeting the price level you choose as your stop order.
A trader’s analysis should always involve weighing the alternatives between the risk of liquidity and the potential profit, This is an important step that should not be skipped and should be included.
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