Understanding Liquidity in the Forex Markets

[RichardCox 10]

When most potential traders start to research the forex markets, most of the common explanations describe foreign exchange as the “largest and most liquid market in the world,” and then go on to cite number of transactions that are made on a daily or weekly basis. In many cases, these articles will also compare the forex to the number of regular transactions that are seen in the stock or bond markets, and, of course, these numbers equal the proverbial “drop in the ocean” when compared alongside one another. But despite the frequency with which these facts are printed, traders will usually disregard liquidity as an important factor when trades are placed.

 

This type of activity is surprising, especially when these areas are disregarded by technical analysts or charting traders. Liquidity is one of the central issues to consider when determining the likelihood that a certain level of support or resistance will hold and continue to remain valid. To be sure, liquidity in the forex market can be confusing to new and old traders alike. Since the forex market is so large, it can be difficult to determine liquidity levels with a high degree of accuracy. But there are still trends that can be identified, and certain market behaviors that are repeatedly seen during certain time of the year. Periods of economic data release also exhibit certain characteristics in terms of market liquidity, so it does make sense to have an understanding of how these factors will influence prices when levels trading.

 

Liquidity vs. Volatility

 

It should be understood that liquidity is measured in terms of the active number of buyers and sellers that are available for transactions in a market at any given time. If I am trying to sell an asset at $100 and there are no available buyers at that price, markets will gap to the next available price. If I am able to find a willing buyer at $100, we can complete the transaction and there will be no gaps in the market price. In this second hypothetical, we are seeing the effects of a transaction in a market with higher liquidity levels. For active traders, this will generally mean that these markets will experience reductions in volatility.

 

In some cases, however, markets can be both volatile and liquid at the same time, but this is usually the result of external factors (such as major news headlines or significant market data). But the strong liquidity levels that are present in the forex market should be viewed as a strong positive when compared to other reforms of trading. The $4 trillion in daily transactions will generally ensure that you are able to get in and out of the markets at the price you want, and will also help trading probabilities in regions of clearly defined support and resistance (since there is a reduced likelihood for false breaks).

 

Examples of Price Extremes

 

If we think back to the Credit Crisis of 2008, we can remember that anyone trying to sell a home missed the benefits of market liquidity. Credit and available cash was much more difficult to come by, and this prevented some home sales from completing, as the negative impacts snowballed. What about a case where a stock trader finds himself on the wrong side of the market (shorting) as the news is reporting that the company is being bought at a premium during afterhours trading? In both of these cases, individuals found themselves in a situation where they could not “exit a trade” at the desired time and price because of the low level liquidity conditions in that were seen in the market environment.

 

While these extremes are not seen to the same extent in the forex markets, there was still major declines in forex market volatility in 2008, and many major price gaps were seen. It should also be noted that the majority of the volatile activity in 2008 was in the downward direction (for stocks and high yielding currencies), and this is no coincidence. In the attached chart, we can see the 2008 price activity in the EUR/USD.

Price gaps generally accompany market uncertainty, so, for certain asset classes, this is a very bearish scenario. This is another way changes in market liquidity can give traders an indication of where asset prices are likely to head next.

 

Signs of Significant Liquidity Changes

 

Since changes in liquidity can have a major influence on trades and trading decisions (giving validity to price levels, and helping determine potential direction), it is important to have an idea of when these changes are likely to occur. A market that is highly liquid might also be referred to as a “deep” or “smooth” market, and this is because the number of active traders is “deep” and overall price activity is usually “smooth.” Some currency pairs have greater liquidity than others. The most commonly traded pairs (such as EUR/USD, USD/JPY, and GBP/USD) will have might higher liquidity levels (and more stable price action), than pairs like EUR/HUF, USD/NOK, or USD/MXN.

 

When managing risks (setting stop losses) liquid markets offer better protection levels. This is because the enhanced volatility that is usually seen after a major break (typical areas for stop placement) can lead to price gaps and more substantial losses. For this reason, some traders stick to liquid markets (commonly traded pairs), traded during stable times (not after data releases or during periods of extreme uncertainty).

 

Spotting Times of Declining Liquidity

 

Since forex is a 24 hour market, there is no added element of session closing (such as what is seen with stock exchanges), but there are still many situations where declines in liquidity can lead to dangerous price gaps. If, for example, a major interest rate announcement or high-interest news event might jar market expectations. In other cases, prices might see gaps as forex market open initially during the Monday Asia session (Sunday night in North America). Price gaps are much less common in forex markets (some studies suggest that 0.5% of forex price activity occurs during a gap), and there are some times during the day that bring reduced liquidity (such as session changes), and these times will be especially important for scalpers and others using short term strategies (which generally require tight stop losses).

 

Asian session hours tend to be less active (favoring range bound strategies), while the London and US sessions tend to be more active (prone to large percentile moves and breakouts), but this activity tends to taper off during the afternoon periods in both areas. Additionally, market periods tend to slow during the Summer months and mid-month periods, while the end of the month will often see activity spikes as a larger number of investors square positions.

 

Conclusion: Stay On Top of Market Liquidity and Its Impact on Prices

 

Most traders tend to disregard the impact of liquidity and the related impact that this can have on price action. When dealing with less liquid currency pairs (or times when markets are holding off from establishing positions), markets are prone to see larger price moves - and these price moves tend to favor certain types of strategies. For these reasons it is important to have a handle on liquidity and its implications, as this can lead to positioning processes that are more streamlined and efficient based on what markets are likely to encounter going forward.

[Spyros 10]

Nice

 

A market order takes liquidity off the market.

Limit orders add liquidity to the market.

 

 

 

The price (bid/ask) that you see is:

Bid: The highest (best) buy limit prices( the highest price that limit buy orders are placed)

Ask: The lowest (best) selling limit prices ( the lowest price that sell limit orders are placed)

 

In the case of few seconds before a major news release spreads widen because the liquidity providers (banks etc) withdraw their orders from the market, (because if the new is "market moving" then there might be an agressive one-side move which they will not be able to hedge against) thus making the difference between the price levels of the orderbook bigger. That means that the distance between the Bid/Ask prices described above widens because the orders 'waiting' at the orderbook are less.

 

While in periods of low liquidity, since the distance between the orders in the orderbook is larger, and the volumes waiting to be executed are smaller, the price moves sharper because there is more distance to move from level to level and the volums at each level are smaller.

 

A market order can move the price to another level if it consumes the liquidity that exists at that level. If there were only limit or stop orders placed then the price would stand still.