The term liquidity is very popular among forex traders, which makes it important to understand this concept, the dynamics that drive it, and how to take advantage of it effectively.
What is market liquidity?
Liquidity is a term used to describe how quickly an asset or commodity can be bought and sold and the stability of the prices. Liquidity is determined by calculating the volume of trades on going or the volume of pending trades vis-à-vis an asset. It is therefore a measure of the number of buyers and sellers available per time trading or ready to trade a particular asset. Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market.
A market can be of high liquidity or illiquid. A market is said to be of high levels of liquidity when there is high demand and supply of an asset leading to a significant level of trading activity. On the other hand, the market is illiquid or of low liquidity when there are only a few market participants (few buyers and sellers).
The Forex Market and Liquidity
The forex market is by far the most liquid in the world, and you can now understand why this is so. This assertion is because of the high volume and frequency with which assets within this market are easily traded. There are several multi-million participants in this market. Examples include governments, central banks, insurance companies, and even individuals trading one currency for the other. This accounts for the huge number of trades occurring in the forex market daily. It is estimated that more than $6.6 trillion are traded on the forex market daily.
Even though the forex market is highly liquid, it doesn’t have stable pricing. Especially during news releases, price movements are greatly affected due to speculations. Among the foreign exchange pairs, the most liquid are the USD pairs especially GBPUSD, EURUSD, USDJPY, etc.
In forex, liquidity matters because it tends to reduce the risk of slippages, gives faster execution of orders and tighter bid-offer spreads.
The Concept of Liquidity Zones
Having gained the concept of liquidity let’s further look at the concept of liquidity zones. Liquidity zone is a term used in technical analysis to describe specific areas on the chart with high market buying and selling activity. These liquidity zones create what is popularly known in the forex circles as support and resistance levels. These levels are seen as reversal signals for most traders.
Identifying Liquidity Zones
The profits associated with high liquidity zone trading cannot be overemphasized. Traders who are able to identify these zones know their relevance. It affords traders the ability to better predict the market trends and avoid unprofitable trades including determining stop loss and take profit areas. The correct identification of liquidity zones is a skill that must be developed. It takes experience and understanding of the forex market including market structure. Here are three methods for identifying liquidity zones on the forex chart.
- Identify Support and Resistance Levels
One of the very initial steps to identifying liquidity zones is the use of candlestick price charts to determine support or resistance levels. Resistance levels are the highest prices reached by specific assets within a specified period. Support levels are the lowest price of an asset or currency pair within a specified period that under normal market conditions can’t be exceeded. These support and resistance levels show traders that the price of a specific currency pair might not appreciate or fall beyond specific price points. These levels are naturally formed on the technical analysis charts as the price moves. They are formed as a result of market demand and supply, economic circumstances of nations, supply levels, central bank policies, etc.
- Price Consolidation Areas.
Consolidation speaks of the oscillating of the price of an asset between particular price ranges. It indicates indecision in the market. It indicates areas where both buyers and sellers are fighting to dictate the pace of the market. This fight to dictate the pace of the market leads to a high volume of trades. Your ability to easily spot these areas of price has consolidated in the past is one of the key ways of identifying liquidity zones since it serves as one.
- Volume profile tool
The volume profile is a tool that presents the volume of trades at different price levels, unlike the usual volume indicators which present volume over time. Due to this, it helps to identify areas where volume surges indicating high probable areas of liquidity.
These support and resistance levels can be determined using indicators such as moving averages, the Fibonacci retracement tool, and the like.
Factors Influencing Forex Market Liquidity
- Market size
The greater the market size of a currency pair the greater the liquidity of that asset as compared to smaller markets. More investors are attracted to such markets. The influx of these buyers and sellers into larger markets helps to easily find counterparties for trades. Overall, high liquidity is afforded. The gold market for example is one of the most liquid commodities to trade because of how large the gold market is. Many participants are drawn to the gold market. In fact, it even serves as a safe haven for investors when the US dollar is getting weak.
- Market Sessions
Market sessions and time of the day are other factors that greatly affect liquidity. The liquidity of currency pairs usually varies throughout the trading day. Liquidity is also affected by the market sessions, accounting for the variation of liquidity within the day. The London and New York sessions are the most liquid market sessions in the forex market due to increased market participation during these times. However, the currency pair being traded is a factor to consider. The JPY pairs for example are more liquid during the Asian sessions.
- News Releases.
One significant period every forex trader consciously or unconsciously is careful about is the times of news releases. News events such as NFP and CPI cause very significant market movements. Whilst traders can become billionaires within a few minutes, most traders who are uninformed tend to blow their accounts during these news releases. These news releases usually increase liquidity in the market and can also bring about a period of illiquidity depending on the news item released.
- Holidays
Holidays are days when most central banks are closed. The central banks are the major players in the forex market, providing one of the largest liquidity needed. Hence on holidays, there is generally an atmosphere of illiquidity. Traders need to be abreast with the forex calendar in order not to trade on holidays and be careful of news releases.
Trading Forex Liquid Markets
Knowledge is power they say. The knowledge of market liquid has made many billionaires. Taking advantage of market liquidity will save you time and make you more profitable. Do you know why? Apart from having your orders filled more quickly in liquid markets at the right prices, it builds your confidence as a trader. The advantages of trading liquid markets cannot be overemphasized. It affords low spread and reduces the chances of slippages which altogether will reduce the cost of trading. To maximize profits from market liquidity the following tips can be helpful:
- Ensure you trade during the most liquid times and sessions of the day. The New York and London Sessions are great times to trade especially during their overlap. The Yen pairs are mostly liquid during the Tokyo session hence you should consider trading them during that session.
- Ensure you check and mark out the Forex calendar to identify holidays and times of certain news releases. It is ideal not to trade on holidays and days of news releases such as CPI and NFP. You can wait and trade after the news releases after the rumbling settles. However, some traders have mastered the art of trading news, if you are of such nothing prevents you except that you must use the right risk management practices. Holidays and periods of political uncertainties usually reduce liquidity but increase volatility·
- Above all, practice proper risk management and money management skills to avoid blowing your account before the market moves in your direction. Ensure you buy at a discount and sell at a premium.
