What is liquidity on the Forex market?
What is liquidity on the Forex market?
You have probably come across the term liquidity in everyday life. For the foreign exchange market, it is of particular importance. In this article, we will look at liquidity on the Forex market: what it is, how and why it changes, and why high liquidity is important.
Liquidity on Forex is a measure of how many buyers and sellers are trading the particular asset and how easily the transactions are made. In other words, the term liquidity refers to the ability of the market to process a transaction without causing a significant change in the exchange rate of the respective currency pair.
In practice, the liquidity of the foreign exchange market usually depends on the number of liquidity providers providing quotes for a particular currency pair, as well as their ability to process large transactions without significantly changing the exchange rate.
Liquidity is considered to be “high” if there is a significant level of trading activity and a high level of supply and demand for the asset, since it is easier to find a counterparty for your position in that case. Today Forex is the most liquid financial market in the world.
What is high and low liquidity?
For clarity, let’s look at an example that is not related to the Forex market. Let's say you have a TV that you want to sell. You post a sale advertisement online. There are many other sellers besides you who also want to sell their TVs. Despite this, you immediately start getting calls and messages from people interested in buying at the original price. In our case, the TV has high liquidity.
Now let's look at another example. You are trying to sell your old and dirty sneakers. There are other sellers of sneakers, but there are few buyers for such a product. When you are finally contacted by one of the buyers, you will have to bargain and most likely drop the price to close the deal. The sneakers are a product with low liquidity.
On Forex, it works in the same way. If a trading instrument has high liquidity, it means at any given time there are many buyers and sellers who are ready to become your counterparty for the transaction. In other words, it is easy for you to open and close a position at your desired price. Major currency pairs such as the EUR/USD are considered highly liquid.
An asset with low liquidity has less volume and fewer open positions, supply and demand are lower, and therefore it is more difficult to make a trade at the desired price. If there are few market participants and they trade rarely, liquidity is considered to be “low”. Exotic pairs such as the NZD/SGD are considered low liquid assets.
Usually, liquidity is calculated based on trades volume, that is, the volume of ongoing trades currently on the market for the particular trading instrument
Liquidity should not be confused with volatility. Volatility is the range of fluctuations in the price of an asset. High volatility is caused, among other things, by the low liquidity of a trading instrument, since low demand causes sharp price jumps. You can find more information about volatility in the article "What is volatility?"
Why does liquidity change?
The liquidity level of a trading instrument can vary significantly depending on the time of day. The beginning and end of a trading session are usually periods of low liquidity.
The Asian trading session is considered to be low liquid. However, spikes in activity occur during the Asian session, especially after the release of important economic news. Peak liquidity can be observed during the European session. In the beginning, it overlaps with the Asian session, then the American trading session starts and there is a surge of activity. Liquidity begins to fade after the opening of trading in New York.
Liquidity also shrinks during major holidays. Each trading session has its own list of such days. You can find out the exact dates in the holiday calendar.
Why is high liquidity important?
Market liquidity is important for a number of reasons, but primarily because it affects how quickly you can open and close positions.
- A liquid market is usually associated with less risk as there is usually someone willing to become a counterparty to your open position.
- The greater the supply and demand, the smaller the spread. The broker can offer the best prices to their clients. This, in turn, attracts more traders to the market.
- A high liquid trading instrument is less prone to high price volatility.
- High liquid trading instruments have large volumes of traded positions, and therefore it is more difficult for large players to influence the price movement against the market during periods of low activity.
Liquidity is one of the most important parameters of Forex trading. Without understanding the main aspects of liquidity and its impact on trading, it will be hard to achieve success on the financial market.
Article last updated: 2022-05-11