It is common knowledge that Forex is a liquid market. What exactly does this concept mean and what specifics about trading should a trader know to become a full-fledged market participant? Let’s figure it out!
What is liquidity?
Liquidity is not a novelty of the 21st century. People realized the importance of this feature back in the ancient time when first trading relations came into being. Understanding liquidity is sure to help a modern trader earn on Forex successfully with minor risks.
In essence, liquidity implies such market conditions in which an asset can be sold with a minimum loss in the buy price from the sell price. Some experts define the liquid market as the one with high supply and demand, which are the features of a liquid asset.
In the context of trading, liquidity means an instant and easy exchange of a trading instrument for money. In liquid markets, buyers and sellers can trade smoothly with tight spreads and low transaction costs.
Gold or short-maturity US Treasuries are highly liquid trading instruments. They can be sold at a reasonable price at any spot on the globe. At the same time, demand for bonds issued by Venezuela is obviously low. A few traders would venture into buying them due to fears that the country could default on its debt.
By analogy with the bond market, the US dollar and the euro are apparently liquid currencies, i.e. they can be sold and bought easily as they both enjoy high demand around the world.
Liquidity of shares depends on how quickly shares of a particular company can be exchanged for money. Here is the perfect scenario in this case. You want to sell shares with steady demand, someone is ready to buy them at your price, and you gain an ultimate profit.
Liquidity of shares depends on how quickly shares of a particular company can be exchanged for money. Here is the perfect scenario in this case. You want to sell shares with high demand, someone is ready to buy them at your price, and you gain an ultimate profit.
InstaForex provides access to a wide range of liquid financial instruments. The company adds more and more assets available for trading. Apart from CFDs on shares, traders can choose from other categories of financial instruments: currency pairs, stock indices, energy, etc.
How liquidity is measured on Forex
Liquidity on Forex is measured through the following criteria:
- Market width or a size of a bid-ask spread
- Market depth or a number of orders at the most attractive prices
- Speed of executing the largest market order
- Resiliency or the market’s ability to bounce back once an order is executed
As a rule, a highly liquid market is characterized by tight spreads and good market depth that ensures fast execution of market orders.
Liquidity categories (low, medium, high)
To understand the ins and outs of liquidity, let’s apply this concept to all popular assets.
All trading instruments can be divided into three categories:
- Low liquid assets. It takes a lot of time until the seller finds the buyer. They are costly items like luxury items, expensive apartments, houses, etc.
- Medium liquid assets. It takes from one week to a few months until a sell/buy deal is executed. Cars, apartments or houses of an average quality belong to medium liquid assets.
- Highly liquid assets. They are sold very quickly. Currencies, futures, stocks, and bonds are all traded in liquid markets.
How liquidity is used in trading
To sum up the above-said information, liquidity is measured by a spread size and a trading volume.
For instance, the largest trading volumes and the narrowest spreads are recorded when trading highly liquid currency pairs such as USD/EUR, GBP/USD, USD/JPY, USD/CAD, USD/CHF, AUD/USD, NZD/USD, GBP/JPY, and EUR/JPY.
Alternatively, low liquid assets in this context are, for example, the Turkish lira, the Mexican peso or the Brazilian real against the US dollar. These currency pairs have such common features as a minor volume of trades and high volatility. Another currency pair yielding small returns is DKK/USD because the Danish krone is marked with a wide spread and low volatility.
The essential factor to bear in mind is that liquidity on Forex can vary during a trading day as major financial hubs operate in different time zones. For example, at the opening bell of the European session, in London in particular, the currency market trades with the utmost liquidity. The market buzz is gradually increasing during the European session until traders from North America enter the market. Liquidity falls sharply by the end of the European trade. Liquidity goes down from the second half of the North American session until its closing bell.
Conclusion
It goes without saying that trading in any financial market requires diligence and appropriate skills. However, having absorbed the theory, a trader is capable of boosting the chance for success. Both novice and experienced traders should grasp the point about liquidity. Without this solid foundation, it is hard to evaluate would-be returns and prospects of any financial instrument.
Being aware of this concept, you will find it much easier to study forex analytics, predict moves of assets’ prices, and develop your own trading strategy with InstaForex.
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