Liquidity and the Foreign Exchange Market

Liquidity and the Foreign Exchange Market

The foreign exchange (Forex) market is often described as the most liquid financial market in the world, and this is true. But this does not mean that currencies are not subject to varying liquidity conditions that currency traders should consider.
Liquidity refers to how much market interest (number of active traders and total trading volume) there is in a given market at any given time. From an individual trader’s perspective, liquidity is usually tested in terms of the volatility of price movements. A highly liquid market tends to see prices move gradually and in small increments. A less liquid market tends to see prices move suddenly and with larger price increments.
The liquidity of the forex market will vary during each trading day as global financial centers open and close in their respective time zones. The decrease in liquidity is being demonstrated for the first time during the Asian trading session. Japanese data or comments from officials may provoke a greater than expected or more sustained reaction just because there is less interest in trading to counter the directional movement indicated by the news.
Peak liquidity conditions apply when European and London markets are open, and overlap with the Asian morning sessions and the North American markets in the European afternoon. After European trading is closed, liquidity drops sharply in what is commonly referred to as the New York afternoon market.
During these periods of low liquidity, currency rates are subject to more sudden and volatile price movements. The catalyst may be news events or rumours, and lower liquidity causes prices to react more surprisingly than they might have been during more liquid periods.
There is no way to predict with any certainty how price movements will develop in such relatively illiquid periods, and this is the bottom line in terms of risk. The bottom line is that if you hold a position in the market during periods of poor liquidity, you run an increased risk of more volatile price movement.

Liquidity is also reduced due to market holidays in many countries and seasonal periods of low market interest, such as late summer and the approaching Easter and Christmas holidays.
Holiday sessions usually reduce volatility as markets come to a standstill and remain range bound. Risks also increase with sudden breakouts and major trend reversals. Aggressive speculators such as hedge funds take advantage of low liquidity to push the markets beyond key technical points, forcing other market participants to respond late, pushing the breakout or reversal even further. By the time the holidays are over, the market may have moved several hundred pips and established a completely new trend.
Just because you enjoy an extended weekend or summer vacation in August doesn’t mean you’re not exposed to unexpected risks from higher volatility in holiday markets. You – and you need to include liquidity conditions in your overall trading plan.