Why Liquidity is Key in Forex Trading

By  //  December 8, 2021

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There are numerous terms and examples of jargon used in the forex market, some of which can be hard for novice traders to understand.

However, some such terms are also crucial to the functionality of the market, with ‘liquidity’ offering a relevant case in point.

But what exactly do we mean by liquidity, and why is it key in the volatile and highly leveraged forex marketplace?

What is Liquidity?

In broader terms, the term ‘liquidity’ refers to the ease with which financial assets can be bought and sold in the real-time marketplace.

In terms of forex, liquidity describes the ability with which a currency pair can be traded, bought or sold on demand, with this varying depending on the nature of the pairing and the fundamental level of demand that exists.

For example, high liquidity forex assets include all major currency pairs, of which there are seven that account for 68% of all forex trades. These pairs pit the US dollar (USD) against seven other major pairs, with the world’s most dominant pairing (the EUR/USD) accounting for more than 24% of the $6.6 trillion traded globally on a daily basis.

Minor and exotic pairings are considerably less liquid, although this varies depending on the underlying asset in question.

Low liquidity in forex suggests that such assets can’t be bought or sold in significant volume without large variances in its exchange price level, making them far from ideal for short-term currency strategies like scalping or day trading.

Of course, more liquid assets also tend to minimise the risk of loss while offering reduced price variance, making them ideal for risk-averse investors who want to avoid the worst of the market’s volatility.

What to Consider When Managing Liquidity

Clearly, there are general rules to adhere to in the case of liquidity, with major pairings significantly easier to buy and sell on demand than most minor or exotic alternatives.

However, it must also be argued that exotic and some minor pairings deliver potentially higher returns due to their increased volatility, so it’s important to create a diverse forex portfolio that strikes the balance between risk and reward over time.

In the case of volatile exotic pairs like PLN/JPY, for example, we may see spikes of increased liquidity during periods of sustained price volatility. This increases the demand among scalpers and day traders, making it possible to capitalise on such trends as a retail investor.

Timing also plays a pivotal role in forex liquidity, which is known to vary throughout the typical trading day.

The Asian session tends to see less active trading hours, for example, reducing liquidity and creating a scenario where support and resistance levels are likely to hold from a speculation perspective.

Conversely, the major moving market sessions are the London and US trading periods, which are more prone to breakouts, inflated demand and larger percentile price shifts over time.