Learn About Liquidity & Why It Is Needed To Trade Forex

Liquidity is one word that is always mentioned alongside trading. If there is liquidity, trading will be easy and the popularity of forex trading can also be attributed to the high liquidity of the currency market. We crave flexibility and the forex market does offer the freedom we desire. It comes as no surprise that the global currency market can beat every other market when it comes to turnover and popularity. The high leverage you get to trade currency pairs creates a lot of opportunities for small and big traders alike.

Leverage is a type of loan that you get from the broker for magnifying the trade size while only keeping a percentage of the total funds needed for the position. It is the margin that you should maintain and you can compute it using a margin calculator. 

So, if you have sufficient account balance to reach the required margin, you can easily enter larger-sized trades. This boosts the total trading volume and enhances the liquidity which is not just a want but a basic need for traders like you and me. This blog will tell you more about liquidity and you will be able to understand why it is a need for forex traders. 

Begin with Basics of Liquidity

Before we learn more, let’s learn some basics that you should know before exploring more about liquidity. If an asset can be used to make money without any hassle, it is said to be a liquid asset. Similarly, if a trade can be opened and closed with ease at the prices you wish to execute the orders, then we can say that the market is liquid. It can also be the liquidity of the instrument being traded which is a currency pair for a forex trader. If no one is selling it, you cannot buy the pair easily. The same applies to those who are trying to sell pairs. 

There should be a buyer who is willing to buy the pair at the same price that you have quoted. Only matching orders get filled in the forex market and others will be cancelled or queued.  Lack of liquidity is mostly due to the absence of buyers and sellers in the market. If there is no demand or supply happening, this will reflect in the prices too. As a result, you will struggle to get the orders filled at the prices you desire. 

The price changing due to a re-quote or spreads going up due to slippage are after-effects of low liquidity.  If the prices are moving rapidly due to high volatility, we need even higher liquidity for trading. The volume of trade and market activity determines the liquidity for the most part. That’s why major pairs are most liquid and easily tradable as you will always find buyers and sellers. 

For example, the EUR/USD pair alone generates 20% of the total trading volume and this makes it a top choice among traders as they can open and close trades at best prices with the tightest spreads. Cross pairs or mini pairs are also quite liquid but more volatile in comparison to majors. The not so beginner-friendly exotic pairs are not touched by many due to the low liquidity and extreme volatility. Moreover, the spreads are higher when liquidity is low and the risk is high as well. 

Even if you have no plans to trade exotic pairs, the risk cannot be fully eliminated and you must take some measures to deal with it. You must place a stop loss in every trade and also set a profit target. You can use tools like profit calculators to get accurate values for trade planning as they instantly estimate outcomes of a trade in advance based on the details you enter. 

How to Keep Track of Liquidity While Trading Forex? 

  • Gaps

All financial markets experience liquidity gaps when a break occurs in trading. For markets with fixed opening and closing times, this gap happens more often. Such gaps also impact asset prices which are still being influenced by news events and other factors. However since the forex market functions round-the-clock, the gap only occurs after weekends when the market is closed. The 24/5 trading hours with 4 time-zone-specific trading sessions, ensure that there is enough liquidity throughout. 

But you can expect some small gaps when traders temporarily stay out of the market during an important news release or event such as central bank meetings or key economic data releases. The volatility will be higher during such events and thus many traders don’t trade until this volatility subsides which causes a liquidity gap. So, keep an eye on the news and use economic calendars to stay updated. 

  • Indicators

You can also use various technical indicators which give information about the trading volume in a currency pair. Some forex brokers even offer liquidity indicators to let you know about the volume of trades that are being executed on their platform. But this is only for reference as this does not include data about the trades placed on other brokerage platforms. However, you can see it as a sample for the total liquidity. 

  • Timing

The liquidity of the forex market does not stay the same throughout the day. Hence, timing is crucial for taking advantage of liquidity. Liquidity is highest during the overlap of major trading sessions as traders from different parts of the world will be active at the same time. The highest liquidity is recorded during the New York and London sessions. 

Factors that Influence Liquidity and The Role of Brokers

The trading volume and volatility have a strong influence on the liquidity level of forex currency pairs in general. It is not just the market that controls the liquidity and trading conditions. Even the broker you choose for trading plays a key role in how you get to access the market. How they provide liquidity and how they execute the orders you place, all of these have to be checked before signing up. 

Market maker brokers actually make the market as they act as counterparties to the trades you place. This type of execution is not very transparent as the broker is directly involved. But if you choose an ECN broker, they simply link you to the market via liquidity providers and orders get executed without any dealing desk interruption. 

The spreads will be lower as there will be deep liquidity formed with the teamwork of multiple liquidity providers. They can be top banks and financial institutions. But Market maker brokers can also provide solid trading conditions. Both types of brokers have pros and cons which need to be considered for making a wise choice. The liquidity arrangement and order execution of your chosen broker greatly influence the trading conditions and trading experience that you get with them. 

Final Remarks

To sum it up, the high liquidity of the forex market plays a key role in making it an attractive place for traders. Because it results in favourable execution prices without any delays and low trading costs along with more market stability. This allows you to enter and exit trades with greater ease at desired prices. 

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