The importance of liquidity in Forex trading

When a trader is new to the forex market, one of the first benefits he likely sees is the level of liquidity in the foreign exchange market compared to other markets. The latest figures show nearly $ 5.1 trillion traded per day according to the Bank for International Settlements’ 2016 triennial report.

The liquidity of Forex makes it easier to trade, which explains the popularity of this market among traders. However, there are some differences in the forex market regarding liquidity that should be taken into consideration. This article explains the concept of liquidity in the forex market and liquidity risk, with the aim of providing a comprehensive understanding of the impact of liquidity on trading.

WHAT IS LIQUIDITY AND WHY IS IT IMPORTANT?

By definition, liquidity on the Change market corresponds to the ability of a currency pair to be traded (bought / sold) on demand. When you trade the major currency pairs, you are operating in an extremely liquid market. Your trading, however, is based on the available liquidity of the financial institutions entering and exiting the market (currency pair) you choose.

Not all currency pairs are liquid. This is because currencies tend to show different levels of liquidity depending on whether they are major, minor or exotic currency pairs (pairs with emerging market currencies). Liquidity decreases as the trader moves from major pairs to minor pairs and then to exotic pairs.

High liquidity:

In Forex, high liquidity means a currency pair can he to be bought or sold in very large quantities with only a minor impact on the movement of its exchange rate, for example major currency pairs such as the EUR / USD.

Other major (very liquid) currency pairs to be aware of are:

Low liquidity:

In Forex, low liquidity means a currency pair He can not be bought or sold in very large quantities with only a minor impact on the movement of its exchange rate, for example exotic currency pairs such as the PNL / JPY pair.

LIQUIDITY OR ILLIQUIDITY IN FOREX: 3 SIGNS TO LOOK FOR

From a trader’s point of view, an illiquid market will be subject to chaotic movements or gaps, because buying and selling volumes can vary greatly at any time. An extremely liquid market is also referred to as a deep market or a regular market and the fluctuation they are also regular. Most traders should go for liquid markets, as it is extremely difficult manage risk in the event of a position contrary to a large-scale movement on an illiquid market.

Here are three signs to look for:

1. GAP DURING FOREX TRADING

In Forex, the gaps are different than in other markets. However, a gap can occur in Forex if a rate or other is announced high-impact news turns out to be contrary to expectations.

A gap can occur at the weekly opening on Sunday afternoon (USA). If there is any news over the weekend, the gaps will generally represent less than 0.50% of the currency value on the Forex.

The graphs below show the difference in liquidity between the stock market and Forex, highlighted by the gaps.

Equity markets are subject to gaps: FTSE 100 Index

The foreign exchange market is little or no gaps:

The importance of liquidity in Forex trading

A market on which trades can be placed 24 hours a day like the forex market it is considered more liquid and simply tends to experience fewer gaps due to the ongoing nature of the market, allowing traders to enter and exit positions whenever they wish. A market where trades can only be placed during part of the day, such as the US stock exchange or the futures market, will be more condensed, because prices can jump out into the open if overnight news turns out to be contrary to general expectations.

2. FOREX LIQUIDITY INDICATOR

Brokers often offer a “volume” option on charts, which traders can use to measure market liquidity. This Forex liquidity indicator is interpreted by analyzing the bars on the volume chart.

Each volume bar represents the volume of trading over a given period, giving traders a good approximation of the level of liquidity. It is important to remember that most brokers only reflect their liquidity data, not Forex data as a whole. However, using a broker’s liquidity as an indicator can represent the retail market appropriately depending on the size of the broker.

3. LIQUIDITY VARY ACCORDING TO THE TIME OF DAY

Short-term traders or scalpers should be aware of the change in Forex liquidity during the session. Some moments are less active, like the asian session, during which the courses are often part of a range, which means the levels of support and resistancethey are more likely to hold their own from a speculative perspective. The busiest sessions, such as the London session or the american session, they are more prone to outbursts and larger movements.

It is during the first part of the American session that you will probably see the most powerful movements, due to the overlap with the European session / London, which alone it accounts for over 50% of the daily trading volume. The American session represents almost 20% of this and during the second part of the session there will often be a noticeable decrease in aggressive movements, except when the Federal Open Market Committee (FOMC) it emits an out of the blue release, but it only happens a few times a year.

LIQUIDITY AND RETURN RISK

In financial markets, the relationship between risk and return is almost always proportional, so it is necessary to fully understand the risks inherent in a trade.

The Swiss franc crisis in 2015 is a good example of liquidity risk in Forex. The This was announced by the Swiss central bank that he would no longer preserve the lower threshold of the Swiss franc against EUR, which had the effect of breaking the interbank market due to the impossibility of fixing the market price. Subsequently, brokers were no longer able to offer liquidity on the Swiss franc. With the return of interbank prices (the cornerstone of currency prices), the course U.S. dollar/ CHF was well off the previous range, which heavily impacted the account balances of people trading the Swiss franc. Although these “black swans” are rare, they are not impossible.

Retail Forex traders need to manage these liquidity risks by lowering the level of leverage using or using guaranteed stops, according to which the broker is obliged to respect their level stop.

The choice between liquidity risk and return should not be overlooked and should be part of a trader’s analytical routine.

FURTHER READING TO ADVANCE YOUR FOREX TRADING

  • The forex market has evolved over the centuries. To benefit from a summary of the main developments that have shaped this market with $ 5 trillion in daily trading, check out our article on history of forex.
  • Our research team analyzed over 30 million live trades to find out the characteristics of a successful trader. Incorporate these features to gain market advantage.
  • Traders often take a look at the sentiment of clients when trading on the forex market. DailyFX provides you with this data, which they rely on IG customer sentiment.
  • If you are just starting out in trading, it is essential to understand the fundamentals of trading in the forex market. Download our free guide of the beginner Forex trader.

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