One of the first advantages that a trader may encounter when starting out in forex trading is that the forex market offers more liquidity than other markets.
The liquidity of foreign exchange can facilitate transactions, making the foreign exchange market popular with traders. After all, in order to ensure liquidity, investors need to consider certain variables in the foreign exchange market.
We will explain the concept and characteristics of foreign exchange liquidity and liquidity risk, and finally seek an overall understanding of how liquidity affects trading.
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What is Forex Trading Liquidity?
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1. Definition of liquidity
Liquidity in the forex market refers to the ability to trade (buy/sell) currency pairs on demand. When you are trading major currency pairs, you are trading an extremely liquid market. However, your trades are based on the liquidity available from financial institutions that allow you to enter or exit trades (currency pairs) of your choice.
Liquidity is the driving force for the market to go up or down, and it is the soul of the market. The direction of funds determines the direction of the market.
In general, the liquidity of the entire financial market can be divided into three levels:
The first layer refers to the amount of money released in a broad sense, that is, the amount of money released in the entire economic system. There is a lot of money, that is, high liquidity, but when the monetary authority issues too much money and the amount of money grows too fast, it will lead to excess liquidity (Excess Liquidity).
The second layer refers to the liquidity of currency in the interbank market, and its main body is the decider of capital supply and demand and price.
The third layer is the liquidity of capital and asset market currency. Compared with the first two levels, it is the liquidity of the individual trader market. A large trading volume means good liquidity, otherwise it means insufficient liquidity. We often say that the liquidity of an asset is poor or insufficient, which means that it is difficult to sell at an ideal price, and the liquidation rate of assets with good liquidity is also high. When liquidity is insufficient, traders face liquidity risk.
In the foreign exchange market, the understanding of liquidity, combined with the above-mentioned explanation of liquidity, we can think that the liquidity of the foreign exchange market is that investors can quickly or at a lower price at a reasonable price according to the basic supply and demand conditions of the market. Only sufficient liquidity can allow traders to enter and exit the market at any time within 24 hours (working days).
The foreign exchange market is the most liquid market in the world, and is traded globally by a large number of retail investors and organizations, so the possibility of sudden flash crashes or extreme phenomena such as "Marketing Gapping" (Marketing Gapping) in the foreign exchange market is relatively low.
That is, for investors, the more liquid the market, the lower the cost of instant transactions. Generally speaking, lower transaction costs correspond to higher liquidity, or correspondingly better prices. The stronger the liquidity of the foreign exchange market, the smoother the transaction and the more competitive the quotation.
2. High mobility:
The high liquidity of foreign exchange refers to currency pairs that can be bought/sold in large quantities without causing large changes in the exchange rate/exchange rate, such as major currency pairs such as EUR/USD.
Other major (highly liquid) currency pairs to watch out for:
GBP/USD
USD/JPY
EUR/GBP
AUD/USD
USD/CAD
USD/CHF
NZD/USD
3. Low liquidity:
The low liquidity of foreign exchange means that the currency pair cannot be bought/sold on a large scale without causing large fluctuations in the exchange rate level, for example: foreign currency pairs, such as the Polish zloty/yen.
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Three signs of forex liquidity to watch out for
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From a trader's perspective, an illiquid market can have chaotic moves or gaps because the level of buying or selling volume at any one moment can vary widely. A highly liquid market is also known as a deep market or a smooth market, and the price movement is also smooth. Most traders need and should demand a liquid market because in an illiquid market it is difficult to manage risk if you are on the wrong side when a big move occurs.
It is worth saying that traders need to watch out for the following three signs:
1. The gap when trading foreign exchange
Gaps in forex are different compared to other markets. However, if there is an interest rate resolution announcement or unexpected major impact news, there may be a price gap in the foreign exchange market.
A gap can occur on Sunday afternoon US time, when the weekly foreign exchange market opens. The overall gap in Forex is usually less than 0.50% of a currency's value if news is released over the weekend.
A market that trades 24 hours a day, such as the foreign exchange market, is considered to be a relatively liquid market, or because of continuity, its gaps tend to be smaller than the stock market. This allows traders to enter and exit the market at will. And a market like the U.S. stock market or futures exchange that is open for only a small portion of the day is compressed into a smaller market because if overnight news goes against what the market expects, prices can jump on the opening bell. time to jump.
2. Foreign exchange liquidity index
Brokers often offer a "volume" option by which traders can gauge the liquidity of the market. This forex liquidity indicator is interpreted by analyzing the histograms on the volume chart.
Each volume vertical bar represents volume for a specific time period, thus providing traders with an approximate indicator of suitable liquidity. It is important to remember that most brokers only reflect their own volume data, not the liquidity of the entire forex market. However, using a broker's volume as a metric can properly represent retail market liquidity based on the size of the broker.
3. The liquidity is different in different time periods of the day
Short-term traders or scalpers should pay attention to changes in foreign exchange liquidity during the trading day. There are some less active periods, such as during the Asian session, where usually the market moves sideways, which means that support and resistance levels are more likely to hold from a speculative standpoint. Market periods with large fluctuations, such as London sessions and US sessions, are more likely to break out or have large percentage fluctuations.
The time of day that you are likely to see the most volatility is the US morning session, as it overlaps with the European/London session, which alone accounts for roughly over 50% of total global daily volume. The U.S. session alone accounts for about 20%, and in the U.S. afternoon, you'll often see prices plummet unless the FOMC makes a sudden statement, which only happens a few times a year.
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What are the benefits of high liquidity for traders
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Having said that, you may still not understand what liquidity means to every trader.
Needless to say, the convenience of using funds is obvious. Another very important point is the openness and transparency of the market brought about by high liquidity.
The high liquidity of the foreign exchange market determines that no capital giant can cause huge market fluctuations through individual large orders and damage the interests of other investors. In a trading market, the more participants there are, the smoother the transaction will be, the more competitive the quotations will be, and the more open and transparent the market will be. In such a market, it is almost impossible to control the flow of the market with one's own power.
Finally, there is another point. Liquidity represents the basic supply and demand of a market, and represents the number of transactions that can be traded at market prices. For a single trader, liquidity represents the cost of quickly executing a certain number of transactions, which determines the transaction Whether the investor can successfully seize the fleeting opportunity to make money.
For traders, the higher the liquidity, the lower the risk, the lower the cost, and the greater the opportunity.
Just imagine, you know that the price is at a high point at this moment, and you can make money by selling it, but it is a pity that you are unable to make a deal due to insufficient liquidity and finally miss the opportunity.
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How Traders Can Judge a Broker's Liquidity
For retail traders, the liquidity of the entire foreign exchange market is not so closely related to everyone. What is important is the liquidity that brokers can provide.
Of course, we can ask a foreign exchange broker what its liquidity providers are. In fact, this is indeed a very necessary thing. However, that's not enough for us to make a decision. Because, sometimes, some foreign exchange brokers may list the names of many liquidity providers, but only a few of them may be qualified.
In addition, even if they connect with the same liquidity provider, different brokers may not receive the same treatment. It is a common law in all walks of life that "big customers" can receive preferential treatment. Brokers with large orders and high quality, corresponding You can also get better prices and higher subscriptions
Therefore, the liquidity provider is one of the criteria for judgment, but not the decisive factor. However, it is difficult for traders to have a quantitative standard for the specific liquidity. Therefore, when traders choose a broker, they should also pay attention to the more intuitive indicators such as the broker's quotation, transaction speed, and slippage.
The best way is to use a small amount of funds to trade first, so as to experience the real trading environment of the broker, and then make further decisions. Especially traders with relatively large trading volumes should pay more attention to the liquidity problems of brokers.
However, it needs to be mentioned that sometimes the lack of liquidity is not the problem of the broker, and it may also be an objective reason. For example, not all currency pairs have sufficient liquidity. The liquidity of different currency pairs is different. The more mainstream currency pairs have relatively better liquidity, and the liquidity of direct trading is better than that of cross trading. Moreover, liquidity is not constant. When a huge market impact arrives, many liquidity providers will withdraw liquidity from the market, causing market liquidity to dry up.
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