When you first start trading, there are multiple terms that you will come across that make little to no sense to you, these are terms such as; Leverage, Margin etc. another one of these terms is Liquidity.
In this article, I want to explain in detail precisely what Liquidity is and why it is important to understand it.
What is Liquidity?
Liquidity in its simplest terms, refers to:
“The amount of trading activity (buying and selling) on a given market or even pair, at any given time. The more ‘liquid’ a market is, the easier it is to buy or sell a particular instrument without affecting its price.”
The advantage here is that this makes for a safer investment because you can exit your position quickly, safe in the knowledge that there wont be a major impact on the price of the instrument traded. It’s the same thing for entering a trade, the more liquid the market the better because when you enter a trade you can be confident that your trade will open at practically the level you entered, and not 200 PIPS out.
So, how ‘Liquid’ is the Forex Market?
The Forex Market is the Worlds most liquid financial market, due greatly to the fact that it is the largest market in the World bar none. So it is the safest market to trade, however traders MUST be aware; that this does not mean certain currencies can not be affected greatly by varying liquidity conditions (check out our Lesson on Fundamental Analysis for a detailed explanation of this).
From an independent traders perspective (that’s me and you!), the liquidity of the Forex Market is seen most clearly with the movement of price. If we were trading a market with a low liquidity, we would look back at previous Price Action and see that actually price hasn’t moved very much at all, and when it does it is rather abrupt.
What makes the Forex Market so ‘Liquid’?
The reason the Forex Market is so ‘Liquid’ is because the varying open and close times of Forex global financial centers, as they commence and cease their trading activity. The image below shows when the main Forex markets open around the World and when they overlap. During this time when they overlap, the market tends to be more volatile and so more liquid.
When liquidity is reduced though (usually during the Asian trading session), price is more vulnerable/reactive to a huge price move, e.g. from Market News. The reason for this is simple, the markets are less volatile, due to the fact that there are less active traders and because there are less active traders, trading activity is less likely to counteract the move. In other words, if you are in a trade during low levels of liquidity, you are at a higher risk of more volatile price.
Why understanding ‘Liqudity’ is so important..
Following on from our last point, if you trade during low levels of Liquidity you are at a greater risk. During holiday periods the market is at a lower level of Liquidity because most people are enjoying a nice break over the seasonal holiday. This is precisely when big market players can take advantage of the decrease in Liquidity, and try to force price to the next Resistance or Support Area. If you happen to be in a trade during this time, be careful. It is best to stick to trading the Major FX Pairs, such as the EUR/USD, GBP/USD etc.