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The Importance Of Liquidity In The Forex Market – Forex Trading Strategies

Liquidity has been an important factor since ancient times and it continues to this day. A person, company or a country can be very wealthy but if they don´t have enough liquidity or liquid assets they can bankrupt easily. Very often we hear about liquidity or the lack of it, during financial crises (like the financial crisis of 2008). Some reputable companies declared bankruptcy at that time because they didn´t have enough liquid assets to pay off their creditors or their clients.

Greece has been in a similar position for about five years and only the extra liquidity provided from the EU has kept the country afloat. In fact, Greece is going through a liquidity ‘starvation’ at this very moment and if it doesn´t get help soon from the EU it will default on the IMF debt repayment, which will officially cause the country to go bankrupt. Liquidity is a key element of the forex market. We will explain below why it is so important for every forex trader.

The most liquid market in the world is the Forex market.

The most liquid market in the world is the Forex market

What is Liquidity?

Let´s start with an example: if during an exam there are 30 people in a classroom, but there is only one pen, how long will it take the whole classroom to finish the exam? There will be great demand for that pen since there are not enough pens to go around. In other words, we are experiencing a pen market with no pens!

Liquidity can be defined as the existing demand for a product or service. How fast can you sell your car and turn it into cash? How fast can you sell your designer watch? In the financial markets, when we refer to liquidity, we mean how easily or fast a specific instrument can be turned into cash, either in an electronic or physical form. Some instruments are very liquid, like gold or short-term US bonds, both can sell quickly anywhere in the world if you´re willing to sell them for a reasonable price. Some are less liquid, take the Greek bonds for example. No one wants to buy them for fear that the country will declare bankruptcy and that investors will not get their premium back. The same goes for forex – some currencies are more liquid than others, like the US Dollar, Euro etc. While small or unstable currencies are less liquid because you cannot use them anywhere apart from the issuing country and, therefore, cannot sell or exchange them for another instrument.

Signs of illiquidity

The stock exchanges around the globe are supposed to be the perfect market, thus very liquid, but that´s not always the case. During major events or off hours, the investors close their positions and the market becomes very volatile. In the stock market charts, like the Facebook chart below, there are plenty of gaps in them. These gaps usually occur when the exchange floors close and the liquidity dries up.

Price gaps caused by lack of liquidity in the stock market.
Price gaps caused by lack of liquidity in the stock market

Although not as often as in the stock market, sometimes in the forex market there are gaps. But the most common signs of illiquidity in the forex market are the long candles that happen in a short period of time. One such event happened on 15th of January this year when the Swiss National Bank (SNB) removed the 1.20 peg they had placed in EUR/CHF. EUR/CHF and all other Swiss Franc (CHF) pairs fell more than 40 cents in a matter of seconds as investors and electronic trading computers withdrew capital from this pair. We can see from the EUR/CHF chart below that the pair had been trading in a tight range for a long time and then crashed in a minute.

 A liquidity hole caused a massive drop in CHF pairs.

A liquidity hole caused a massive drop in CHF pairs

All the market’s participants add liquidity to that market. Individually, some of the biggest names in the banking sector stand out in the forex market. These are called Tier 1 liquidity providers and include Deutsche Bank, Citi, Morgan Stanley, HSBC, UBS, Bank of America, Barclays, Goldman Sachs etc.

Retail trading has grown consistently and it is an important portion of the liquidity. It is estimated to account for more than 12% of spot turnover. Brokerages that operate as Dealing Desks are part of this and act as liquidity providers. They allow clients to buy and sell currencies and hedge their clients’ positions in the real market or internally.

The US Dollar is the most traded currency.

The US Dollar is the most traded currency. Nowadays, most of the trading volume in the forex market is brought about by speculators and some argue that this accounts for more than 90% of the market. Most of the world has realized and accepted the importance of speculators and the liquidity that they add to the markets.

China was the latest to accept and introduce speculation to its financial markets. They opened the door to their markets for speculators a few years ago but decided to kick them out again. It didn´t take long before they begged them to come back. Since the introduction of the high-frequency trading, their size of market share has increased and now they play an important role in providing liquidity. Since they execute millions of trades a day, they are willing to buy or sell instruments at any time, thus providing liquidity.

Importance of liquidity to a Forex trader

The foreign exchange (forex) market is a decentralized global market. Apart from the Frankfurt exchange floor, which counts only for a very small percentage of the foreign currency exchange, the forex market doesn´t have a physical location. The buying and selling of the currencies is executed electronically, primarily between banks, hence the name ‘interbank market’. But there are other participants as well, such as investment and hedge funds, pension funds, insurance companies, corporations etc.

As of April 2013, an average of $5.3 trillion is traded in a single day in the forex market. This makes it the biggest market in the world by far, and the most liquid market that has ever existed. This means the trading volume is extremely high and the amount of buying and selling is high most of the time. You can open a trade at anytime during the day, anytime during the week, 24/5.

The trading volume in the forex market has passed $5 trillion a day.

The trading volume in the forex market has passed $5 trillion a day. From the point of view of a trader like me and you, the biggest benefit of a liquid market like forex is that it is easier to trade. Of course, there are times of high volatility, but this is less affected by outside shocks such as economic news or political events.

Liquid markets tend to follow crowd behavior, which is easier to read than the single investor behavior, characteristic of the less liquid markets/instruments. You can get a good sense of a large crowd’s sentiment, but you cannot know what´s in the heads of a small group of people with no relation to you. That´s why it is easier to predict the direction and the price action of a more liquid market.

Since a liquid market is more logical, it follows price patterns like trends, support and resistance levels etc, more strictly than a non-liquid market. So, another advantage of liquid markets for a trader is that it is easier to be exploited by mechanical trading systems; it´s for this reason that algorithmic trading has become very popular in forex. You can apply automated trading systems in thin markets as well, but you´ll get lots of whipsaws which come from low liquidity and which a mechanical system cannot predict.
A liquid market is more logical, it follows price patterns like trends, support and resistance levels etc.
A liquid market is more logical, it follows price patterns like trends, support and resistance levels etc. Liquidity minimizes losses – there is no worse place to be than the wrong side of a trade in an illiquid market. Imagine that you are long on a stock and the next trading day it opens with a 200 pip gap lower. This is very common in the stock market as we showed in the Facebook chart above. How about if you were long on EUR/CHF – just above the peg at 1.20? Well, many were and a lot of accounts were blown off during that one-minute liquidity hole. But such events are very rare in forex, so we can say that it is safer to trade in this market than in other less liquid markets.
The price fluctuation or volatility in a liquid market is lower than in a less liquid market, so the spreads are much smaller, which is another advantage for a retail trader. Certain brokers offer spreads as low as 0.2-0.3 pips in most liquid pairs such as EUR/USD and USD/JPY. The spreads of the biggest companies´ shares, which are traded in the stock exchanges, are normally 20-30 pips average spread while the spreads of all the forex majors offered by a normal broker stand at 1.5-2.5 pips. That comes from high liquidity in the forex market and makes it very easy for traders to use different trading strategies that cannot be applied to the stock or other less liquid markets.
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