Forex trading is a trader’s best friend as it offers not only one but many opportunities. It is not hidden that everything comes with its drawbacks, but the benefits of forex trading have the upper hand. One of these benefits that attract traders towards forex trading the most is its liquidity. The forex liquidity makes it the trader’s favorite in the security market. However, due to the unforeseen variations in the Forex Market, one must understand the forex liquidity strategy.
As stated in a 2020 triennial report by the Bank of International Settlements, the forex liquidity is around $6.6 trillion per day.
What is forex liquidity?
Forex liquidity represents the volume of all trades in the market for particular currency pair or whole forex market. In simple words, forex liquidity shows how much money circulates in forex. High liquidity implies a significant level of trading activity and high supply and demand for an asset.
The definition of forex liquidity is quite similar to that of general liquidity. It means how easily and on-demand two currencies can be traded in a forex market. It simply depends on what type of currency you are trading in. The types of currencies classified in the forex market are major, minor, and exotic, out of which major currency pairs are considered to have the highest liquidity. However, the liquidity strength of the financial institution one is trading with needs to be considered. Also, the liquidity strength decreases if the trader moves from major currency pairs to exotic or minor currencies. This is because all currency pairs do not have the same kind of liquidity.
How to find liquidity in forex?
To find liquidity in forex, you need to calculate how much money circulates in forex, to use technical indicators based on market volume measurement such as:
- Chaikin’s cash flow (CMF) ;
- Mass Index Oscillator;
- Money Flow Index (MFI);
- On Balance Volume (OBV);
- Percentage Volume Oscillator (PVO)
- Price change rate (ROC);
- Volume Zone Oscillator (VZO);
High liquidity in forex refers to a pair of currencies that are traded in large amounts with little variation in price or exchange rate.
The following is a list of major currency pairs with high liquidity potential:
Low liquidity in forex refers to a pair of currencies that cannot be traded in large amounts without significant price or exchange rate fluctuations. It simply means that there will be significant variations. This is common when trading exotic currency pairs like the PLN/JPY, USDMXN, and others.
Difference Between Forex Liquidity and Illiquidity
The difference between forex liquidity and illiquidity is in overall pair volume, which is moderate to high in the liquidity market. In contrast, there is no demand or supply in the liquidity market, volume is low, and making instant market trades is difficult. The trading price range is very small in illiquid markets, and the price does not change frequently over time.
The more liquid forex trading is, the smoother the price action is. Furthermore, the currency pair’s buying and selling are less chaotic. A plunging market is a market that is probably unnecessary.
The illiquid market, on the other hand, is extremely chaotic due to the fluctuating volume of currencies traded at any given time. The illiquid market is risky because traders who do not trade on the right side of the illiquid market can lose a lot of money.
Forex liquidity strategy
In forex, the entry position trigger is usually used when volume is above or below the average range. Traders typically look for an important increase in volume as a sign that the trend is also strong. The volume change detection process, trading gaps, and different trading sessions are all used in forex liquidity strategies.
Gaps In Forex Trading
News that is more powerful than expected, such as interest rate announcements, can have a significant impact on the forex market’s gaps. However, when compared to other security markets, the forex market has fewer gaps.
When comparing the forex market to the Futures Exchange or the US stock market, the forex market has fewer gaps than the other two. This is due to the fact that the forex market is open for business 24 hours a day, seven days a week. This makes it more liquid than other markets, and traders can easily enter and exit the market at any time. Other markets may exhibit erratic price action when they open, as a result of some unexpected announcements made overnight.
The Indicator of Forex Liquidity
The forex liquidity indicator is a bar chart that shows how a trader traded in the forex market. Each bar represents the volume traded by a single trader over a specific period of time. That is, it is a trader’s chart rather than a market chart. As a result, it can only be used to analyse the forex liquidity of a specific trader’s volume, not the entire market.
Looking at the bars, one can estimate the forex market’s liquidity based on the volume traded on the chart.
Different Trading Sessions and Liquidity
The forex market is open 24 hours a day, seven days a week. And it’s not as if the trader can count on the same level of liquidity at all times of the day. You should be aware of the times of day when the FX market is most liquid compared to other times, especially if you are a short-term trader.
The FX market is highly anticipated around the world because it trades almost all of the world’s currencies. As a result, the forex market can be classified into different sessions divided into different markets, each with its own level of liquidity. When the US morning session meets the London/European session, it is the most active and liquid time. This session is estimated to account for more than half of the daily global volume traded. Traders can see a significant drop in volume traded during the US afternoon session. However, there are exceptions, such as when the FOMC (Federal Open Market Committee) makes a surprise announcement. Due to speculations directly controlling support and resistance, the Asian session is also less active and low on liquidity. As a result, during the US and London sessions, the larger breakouts can observe.
Liquidity Risk And Reward
Every trading strategy includes a risk and reward analysis. It is an important aspect of the financial market, and everyone understands that risk and reward are proportional. As a result, the higher the risk, the higher the reward.
The 2015 Swiss Franc crisis, when the Swiss Central Bank announced that the Swiss Franc peg to the Euro would be scrapped by 1.20, exemplifies the Forex Liquidity risk. The Swiss franc’s liquidity plummeted as a result of this announcement, causing a ruckus among brokers. It left its imprint on the market even after it was reintegrated.
These types of risks are unexpected, but this example shows that they are not impossible to take place. Lower leverages and stop-losses can also help mitigate risk.