Shifting Liquidity Conditions Can Increase Currency Trading Volatility

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 drop in liquidity is first evident during the trading session in the Asia Pacific region, which accounts for only about 21 percent of global daily trading volume.
Japanese, Chinese or Australian data or comments from regional finance officials may trigger a greater than expected or more sustained reaction just because there is less trading interest 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 and interest, currency prices are prone to drifting in tight ranges, but they are also susceptible to sudden and volatile price movements. The trigger can be a news event or rumor, and lower liquidity causes prices to react more surprisingly than they would during more liquid periods.
Another common source of erratic price movements during less liquid periods is the short-term market situation. The classic example is the strong rally of the currency pair during the North American morning/European afternoon. With Europe heading home, the currency pair usually settles in a consolidation range near the upper end of today’s rally.
If enough short positions are established on the rally, further price gains may force some short selling to buy and cover. With low liquidity, prices may jump suddenly, triggering an influx of similar buying from other short positions, resulting in a short pressure spike.
The same phenomenon can occur after market dips, where long market long positions are forced to exit impulsively with further price dips. Still another contrast on this topic is the sharp price reversals of a previous rally, where long positions take profit under weak conditions and the resulting lower price sells other impulsive longs to maintain profits. After selling, profit taking on short positions can lead to a sharp reversal of short positions being covered.
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 these periods of poor liquidity, you are at increased risk of a 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, approaching Easter and the Christmas/New Year 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 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’re enjoying an extended weekend doesn’t mean you’re not at risk of the increased volatility in the holiday markets. You – and you need to include liquidity conditions in your overall trading plan.