Forex liquidity influences the technique in which the trading is done as higher liquidity enables better trading. It enables convenient swapping conditions for a trader. In the case of major currency pairs trading, a trader has to deal with a high liquidity condition. The liquid state is because of the 24-hour trading done on weekdays.
Another reason is the mammoth turnover of around $6 trillion that happens per day here. The actual trading, however, is dependent on the liquidity of the financial institutions that aid in entering or exiting the pair a trader selects.
Interpretation of Liquidity
The swiftness and cost at which a trading instrument is sold are referred to as liquidity. For instance, imagine an asset that has a basic or real value of $200. If you can turn the asset into cash of the same amount or an equivalent value, it shows the asset has good liquidity. But, this is not possible entirely in reality.
Liquidity denotes the sellers and buyers and the effortless way transactions are made. It is assessed by considering the trade volumes or undecided trade volumes in an existing market. High liquidity occurs when the trading action is considerably high with an asset’s demand and supply state also being high. This makes it easy for the asset to be sold or bought. Liquidity is said to be low when the partakers are few in number and infrequent trading is present. Such a market is called illiquid.
Significance of Liquidity
There are various reasons cited for the crucial value of liquidity in forex. The chief one is its power on the quick trading conditions. There is reduced risk as you can always find a seller or buyer. This lures more traders and improves the market condition.
In a high liquid state, it is easy for a seller or buyer as there is no necessity to reduce or raise the price. Another significant factor is its influence on the spread provided by a broker. So, in better liquidity states, more orders can be purchased or sold.
The probability of a buyer accepting the highest rate or a seller accepting the lowest rate happily becomes closer. In short, the spread for the bid-offer constricts. Conversely in an illiquid market, there is a widening of the spread.
Application in Forex
As liquidity plays a vital role in opening and closing positions, a higher risk is always present when low or no liquidity is present. With a volatile market, you will find very few buyers so picking a close position is difficult.
However, it is imperative to note that it is not a fixed state. It is constantly changing based on the time and trading volumes in a day. For out of market hour trading, there will be scarcer participants, making the liquidity reduce.
Although forex is known for its high liquidity, stable pricing does not happen. The diversity in price-fixing by traders on major pairs causes constant price movement. However, major currency pairs, such as GBP/USD, EUR/USD, USD/JPY, exhibit better liquidity. This implies there is a lower risk of errors, the spreads are closer, and orders are executed quickly.
When considering risks in forex, traders should weigh it proportionately with the profits. This can occur only when the risk is understood properly. Liquidity risks can be dealt by reducing leverage. Traders can also use assured stops so a broker has to stand by the stop level you have placed. Thus, assessing the liquidity risk should be an integral part of the analysis done by a trader.