The forex market is the largest in the world, with a significant amount of volume being traded, making it an extremely liquid market. These factors can result in periods of high and low volatility.
Liquidity and volatility are two important concepts in the forex market. Volatility refers to the amount of price movement over a certain period, with higher-than-normal activity often referred to as a volatile market. Liquidity is how easily an asset can be converted into cash at its current market price.
However, it's never that straightforward. Below you can find out what causes liquidity and volatility to rise and fall, as well as how they can be used in your trading.
What is Liquidity in Forex?
Liquidity is how liquid an asset is — in other words, how quickly an investor can convert the asset they are invested in into cash at the current market price.
A highly liquid market means an investor can jump in and out of an asset and have no problems entering or exiting at a specific price.
In contrast, an illiquid market, otherwise known as a thin market, means the asset cannot be easily and readily sold or exchanged for cash. As a result, thin markets will usually have significantly large spreads, resulting in increased transaction costs.
What Causes Liquidity?
In forex, traders are able to see changes in liquidity by assessing the pair’s current spread on their broker’s platform. The spread is the difference between the bid and ask prices. If the liquidity is high, it will usually result in tighter spreads, while if it is low, spreads will widen.
The factors that impact forex liquidity are supply and demand and forex market trading hours. For example, if more traders and investors buy and sell, liquidity will increase, lowering spreads.
In addition, while the forex market operates continually across the world, the official openings and closings of global financial centers impact forex liquidity. The most liquid session is the London-New York overlap, with London accounting for most forex trading volume, just in front of New York.
How to Use Liquidity in Trading
Traders should choose a liquid forex pair to trade as it allows the pair to be bought and sold on demand. In addition, trading pairs with high liquidity will reduce spreads and other trading fees. An example of a highly liquid pair is EUR/USD, which generally has just over a one-pip spread on the OANDA platform. In contrast, a pair such as the HKD/JPY has a spread of well over 10 pips on the same platform.
What is Volatility in Forex?
Volatility in forex trading measures the magnitude of a currency pair's up and down swings. When the price of a currency varies rapidly, both higher and lower, it is considered to be volatile. Low volatility refers to a currency pair that does not change as much in price.
What Causes Volatility?
Market uncertainty causes volatility in a forex pair or pairs. Various factors can cause uncertainty and volatility, including geopolitical factors, trade issues, market sentiment, liquidity and monetary or fiscal policy.
For example, decisions by governments and political leaders regarding trade agreements, policies and lawmaking can result in strong reactions as they may impact the supply and demand of a currency.
A change in sentiment can also have an impact. For example, demand for a currency can be impacted by a negative view of its economy, while changes in monetary policy will also affect demand. For instance, if a central bank increased the pace of rate hikes, investors and traders would see that currency as more desirable, which could result in a surge in its price vs. another currency.
How to Use Volatility in Trading
When trading in high volatility periods, some traders will use a strategy whereby they make quick trades to capitalize on the sizeable intraday market swings.
In addition, traders can use the volatility from scheduled news events to enter and exit the market or use the initial volatility in a particular forex pair to fade the move.
Another way traders can use volatility is to implement certain indicators on their charts. This process may help to execute a volatility-focused trading strategy better. However, it is vital to use appropriate risk management tools such as stop losses and reduced position sizes when trading using volatility. The wide swings in either direction will increase the potential for significant losses.
How Liquidity and Volatility Affect Each Other
The liquidity of a market has a significant impact on how volatile its prices are. Liquidity and volatility affect each other, with reduced liquidity usually leading to a more volatile market with large price swings. In contrast, higher liquidity usually results in a less volatile market with smaller price fluctuations.
For example, liquid markets like major forex pairs tend to move in smaller increments as the higher liquidity results in lower volatility. If many traders are trading simultaneously, the price frequently makes tiny up-and-down fluctuations. On the other hand, fewer traders and a thin market will result in increased price fluctuations.
Two Vital Forex Concepts
Liquidity and volatility are two concepts that are equally important to understand when trading the forex markets.
While traders may want to avoid specifically trading using volatility and liquidity as their primary strategy for entering and exiting the market, they are important concepts that impact every trader at some point, especially when executing a trade with a brokerage.
Frequently Asked Questions
Does liquidity affect volatility?
Yes, liquidity affects volatility, with reduced liquidity usually leading to a more volatile market.
What are the four types of volatility?
The four types of volatility are historical, implied, the volatility index and intraday volatility.
Why does low liquidity cause volatility?
When liquidity is low, the lack of buy and sell orders means less activity to absorb market fluctuations.
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About Sam Boughedda, Stock Market Analyst
He is an expert in the following spaces: stock market news writing, analysis, and research.