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);
Forex high liquidity refers to a pair of currencies traded in considerable amounts without significant variations in their price level or exchange rate.
Following is the list of major currency pairs that can be highly liquid:
Forex low liquidity refers to a pair of currencies that cannot be traded in considerable amounts without significant variations in their price level or exchange rate. It simply means that significant variations are expected. For example, this generally happens when trading with exotic currency pairs like PLN/JPY, USDMXN, etc.
Difference Between Forex Liquidity and Illiquidity
The difference between forex liquidity and illiquidity is in overall pair volume, wherein liquidity market volume is moderate to high. In contrast, in the liquidity marker,t there is no demand or supply, volume is deficient, and it is tough to make instant market trade. In illiquidity of the market trading price range is very low, and the price does not frequently change over time.
The smoother the price action, the more liquid is the forex trading. Also, the buying and selling of the currency pair are less chaotic. This highly liquid market is called a plunging market.
On the other hand, the illiquid market is very chaotic due to the uncertain volume of currencies traded at a particular time. The illiquid market is precarious as traders can lose a significant volume if they do not trade on the right side of the illiquid market.
Forex liquidity strategy
Forex liquidity strategy in forex usually uses entry position trigger where volume is above or below average range. Traders usually wait to see strong volume increase as a signal that the trend is strong too. Forex liquidity strategies are based on the volume change detection process, trading gaps, different trading sessions.
- Gaps In Forex Trading
Powerful news or interest rate announcements beyond expectations can significantly influence the gaps in the forex market. But the gaps in the forex market are less as compared to other security markets.
If we compare the forex market with the Futures Exchange or the US equity market, we will see fewer gaps in the forex market than the other two. This is simply because the forex market is open to trade 24 hours. This makes it highly liquid than the other markets, and there is an ease of entry and exit for the trader, in and from the market, at any point in time. Other markets can give an uncertain price action while opening, which is caused due to some unexpected announcements made overnight.
- The Indicator of Forex Liquidity
The forex liquidity indicator is a bar chart that can be read to understand how a trader traded in the forex. Each bar shows the volume traded in a given time by a single trader. That is, it is not a market chart but a trader’s chart. Therefore, it can only be used to analyze the forex liquidity of a volume traded by a specific trader and not the whole market.
One can look at the bars and estimate the liquidity of the forex market as per the volume traded as per the chart.
- Different Trading Sessions and Liquidity
The forex market runs 24 hours. And it is not that the trader can expect the same level of liquidity at any point of time throughout the day. Especially if you are a short-term trader, you must be aware of the times of the day when the FX market is highly liquid compared to other times.
The FX market is highly anticipated globally because almost all the currencies available are traded here. Therefore, the forex market can be identified through different sessions divided according to different markets, and each session has its varied level of liquidity. The most active and liquid time is when the US morning session imbricates with the London/European session. This session approximately estimates at more than 50% of the global volume traded daily. While in the US afternoon session, traders can observe a significant fall in the volumes traded. But the exceptions are there, and it is when the FOMC (Federal Open Market Committee) makes an unexpected announcement. The Asian Session is also less active and low on liquidity due to the speculations directly controlling the support and resistance. Therefore, the larger breakouts can observe during the US sessions and the London sessions.
Liquidity Risk And Reward
Analyzing the risk and reward is a part of every trading strategy. It is an essential part of the financial market, and every person knows that the risk and reward are directly proportionate. So the more risk you take, the reward can be expected.
The Forex Liquidity risk can be understood with the example of the 2015 Swiss Franc crisis when the Swiss Central bank announced that they would scrap the Swiss Franc peg by 1.20 to the Euro. This announcement caused a commotion amongst the brokers as the liquidity of the Swiss franc fell. Even after it was reintegrated, it left its marks on the market.
These types of risks are not seen often, but this example is a piece of evidence that it is not impossible to happen. And to tackle these risks, lower leverages and stop-loss can be useful.