If you read at least one article describing the benefits of Forex then you probably already heard about the “high liquidity” of the currency market. But for a novice trader, these are just empty words. How do you know that high liquidity is an advantage if you don’t understand the actual meaning of the term?
It's time to talk about this concept and tell you what time it is best to open and hold your trades considering the level of liquidity in the market.
What Is Liquidity
I could give you an abstruse economic and historical excursion and talk about the origin of the word itself and its application in various fields. But I would better explain this term to you in a simple and understandable manner.
Liquidity is basically the level of supply and demand. With a high level, you can quickly sell or “liquidate” any goods. In Forex, you can easily trade currencies even in large volumes and be sure that you will easily liquidate your position at any moment. That is why a high liquidity level in the currency market is considered an advantage.
Main Types of Liquidity
Regarding liquidity in financial markets, it's essential to understand the main types of liquidity. The two primary types of liquidity are market liquidity and funding liquidity.
- Market liquidity is the ability to quickly trade an asset without causing significant price changes. It usually depends on trading volume, the number of traders, and market depth.
- Funding liquidity refers to the availability of cash or short-term funding to fulfill financial obligations. It focuses on the ability of market participants to obtain the necessary funding to keep their trading activities or cover operational costs.
Both market liquidity and funding liquidity play essential roles in the functioning of financial markets.
The Impact of Liquidity in Forex
So, we already know that a high level of liquidity allows us to liquidate large trading positions. The speed with which instruments are bought and sold on the market obviously affects the price movement. Therefore, the level of liquidity on the Forex affects volatility. So basically, the way price moves on your charts often depends on volatility:
- With high liquidity, the chart moves smoothly, without sharp jumps.
- With low liquidity, the market behaves erratically and you can often experience slippage and gaps.
Remember though that the impact is not always direct. It happens that with high liquidity there is low volatility in the market, and vice versa.
Pay attention also to the major economic news releases. Even with high liquidity, they can cause sharp jumps on the charts. During these periods, many market participants don’t want to risk their capital and try to avoid trading, which provokes a drop in supply and demand and a further decrease in liquidity.
About Liquidity of Different Instruments
Forex is the most liquid market as money will always have a high demand in the world. Every moment, people exchange it for various goods. That’s why currencies always have a high demand. Not surprisingly, Forex trading volumes are measured in trillions.
The most demanded currency in the world is the US dollar. About 62% of the total transaction volume contains the USD. That is why major currency pairs are the most liquid in the market and you are unlikely to find yourself in a situation where you simply cannot liquidate your position.
Liquidity in Different Periods of Time
Liquidity levels vary throughout the day. Of course, there are many influential factors but usually, the least liquid trading session is Asian. The increase in demand is observed closer to the London session. It holds through the New York session and declines towards its end.
Considering these indicators, the European and American sessions are the best time to trade. The chart at this time moves smoothly and most often has a more precise direction, which means that the market has lower chances to go flat.
The liquidity level is greatly reduced after the closure of all trading sessions. The market begins to behave unpredictably and the level of risk rises significantly. That is why day traders never leave their positions open at night. The chance that the volatility will sharply increase and, as a consequence, you will lose a huge part of your capital is too high.
The season also affects liquidity. At the end of summer and before the New Year holidays, the demand for currency is sharply reduced. There are far fewer market participants. Such a market is called “thin” and “weak”. Some major Forex players love using this “weakness” to their advantage. As there is a small number of open trades, they often easily manage to reverse the market in their favor. Partially because of this, many regular Forex traders try to avoid trading during these periods.
Disadvantages of Low Liquidity
With low demand for currencies, trading conditions often get worse. It happens as usually during low liquidity the spread widens. If you trade on a floating spread, you should try to open your trades during high liquidity periods.
High demand also affects the speed of order execution. The lower the liquidity, the slower orders are executed and the higher the chance of requotes.
To Summarize
What did we learn today? High liquidity gives us a number of advantages:
- The market moves more smoothly, without slippage and gaps
- Spreads and requotes are lowered
- Order execution speed is higher
You could say that you should avoid trading during periods of low liquidity. To do this, it is better not to open trades during the major economic news releases, trade mainly in the London and New York sessions, and also try to avoid trading during the periods before large holidays, as well as in late summer and before the New Year.
It seems that these are all conclusions for today. I hope the term “liquidity” has become a little clearer to you and you can apply this knowledge in trading to improve your performance.