How Do I Determine Forex Liquidity?

When a currency is easily bought and sold without a lot of fluctuation in its exchange rate, it is considered a liquid currency. With an estimated average daily trading volume of $4 trillion, the foreign exchange market is by far the world’s largest market . Due to this size, market participants commonly regard foreign exchange as highly liquid at all times – liquid in the sense that you can buy or sell very large sums quickly and without turning the price against yourself by much.

To quantify illiquidity costs, we develop an example of a speculator who engages in the AUD/JPY carry trade, i.e., she borrows in low yielding Japanese yen and invests in high yielding Australian dollars. She is forced to unwind her position when markets are illiquid, for instance, because she is not able to roll over short-term positions. In a realistic scenario of sudden exchange rate movements in conjunction with high bid-ask spreads, we show that the speculator Fiduciary loses 13% of her capital – 25% more than in the benchmark case without Forex liquidity cost. In an effort to become as transparent as other financial markets, many forex brokers offer Level II trade screens. A Level II screen allows you to see exactly how much currency is available at the current price as well as at levels above and below the current price. Liquidity is essential to efficient trading in the foreign exchange market or any market for that matter.

Liquidity Definition

Liquidity describes the extent to which an asset can be bought and sold quickly, and at stable prices, and converted to cash. The most efficient method to calculate what is liquidity in forex liquidity is to measure the spread between the bid and ask prices. If you still want to trade barely usable securities, don’t buy them for an extended period.

The theory of liquidity spirals implies that traders are forced to liquidate positions when funding liquidity diminishes. This selling pressure reduces market-wide liquidity and triggers large price drops. We provide evidence that when traders’ funding liquidity decreases, market-wide Forex liquidity drops, which then affects exchange rates via their liquidity betas. A liquid asset is one that can be bought or sold quickly at a minimal loss to its value at any time within market trading hours. The key characteristic that is used to identify a liquid asset is that it always has ready and willing buyers and sellers.

How Is Liquidity Calculated?

Some shares trade more actively than others on stock exchanges, meaning there is more of a market for them. In other words, they attract greater, more consistent interest from traders and investors. These liquid stocks are usually identifiable by their daily volume, which can be in the millions, or even hundreds of millions, of shares.

During such low liquidity periods, the currency markets are subjected to large and abrupt price movements. Reduced liquidity makes prices react aggressively to market news and rumours. For traders, maintaining positions during times of such low liquidity means greater exposure to volatility risks. Market liquidity depends both on the asset you’re trading and market events.

Cons Of Liquidity

For example, the liquidity of a stock is measured by how quickly and easily it can be converted to cash. If it is difficult to convert an asset into cash, then it is considered illiquid. Liquidity is used in finance to describe how easily an asset can be bought or sold in the market without affecting its price – it can also be known as market liquidity. When there is a high demand for an asset, there is high liquidity, as it will be easier to find a buyer for that asset. Liquidity isn’t created out of thin air, or by a small trader in the U.S., Europe or Asia. It is generated by a liquidity provider, which is by definition a market broker or institution which behaves as a market maker in a chosen asset class.

There are two frictions that lead markets to be less than perfectly liquid, or illiquid. This can attract more traders to the market, which adds to the favorable market conditions. So in a perfectly liquid market, someone who is looking to buy an asset whose fundamental value is $100 will be able to purchase that asset instantly for exactly $100 and receive it instantly.

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Market holidays, such as Easter and Christmas, also coincide with periods of low liquidity. Typically, the FX market sees low volatility during such times, with rising instances of ranging conditions. Sudden breakouts and trend reversals tend to occur during this time, leveraged by aggressive speculators, such as hedge funds.

The creation of a liquidity level comes as a result of an initial imbalance of supply/demand, which forms what we popularly know as a swing high or swing low. As more players take positions in the market, these are levels where market participants will use as a historical reference to place their stops. The binary outcome here can be a breakout of the level or a reversal back to the mean. If you are a discretionary trader, this article will hopefully enhance your understanding of the locations to consider key areas in a chart where opportunities may arise. Financial analysts look at a firm’s ability to use liquid assets to cover its short-term obligations.

Trans-National Corporations – companies doing business abroad also provide liquidity to the forex market, as well as large domestic corporations who buy raw materials from other countries. These participants are largely hedging their forex risk with their transactions and they add liquidity by acting as customers of large banks. Commercial Banks – they usually provide considerable liquidity to the forex market, often acting as market makers and speculative traders. Fourth on our list is GBP/USD or the Pound Sterling quoted against the U.S. This pair is also sometimes called “Cable” since quotations in this currency pair were historically made via the transoceanic cable. Typically, dealing spreads in this pair are between two and four pips wide, and it tends to have a higher volatility and a lower trading volume than EUR/USD, for example.

• Forex market liquidity is in turn tied to market-wide liquidity of other asset classes such as equities and bonds, highlighting that liquidity shocks are a cross market phenomenon.
• However, if the credit demand increases worldwide, it poses a situation of people not having enough money to put into investment arenas, depicting less liquidity while Forex trading.
• During such low liquidity periods, the currency markets are subjected to large and abrupt price movements.

It is important to note that they do not always quote their clients and other professional counterparties the prevailing market price. Instead, they generally quote a two-sided price based on how they anticipate currency movements will take place and what they think the counterparty might be interested in doing. Since the trading volumes of tier-1 liquidity providers are always on the higher side, their transactions can affect market supply and demand forces in the short term.

Learn About Financial Liquidity

Liquidity providers are major banks, licensed investment companies and brokers. Trading process via STP technology implies that all orders of our clients are automatically transferred to liquidity providers without any interference on the part of the broker. In this case, the profit clients receive doesn’t yield any losses to the broker. Trading in the above currency pairs, which are fibonacci sequence the most traded forex instruments in the world, usually presents the active trader with the best opportunity to make profitable transactions due to low transaction costs. Outside of these major pairs and currency crosses, a forex trader will find currency pairs with fairly wide bid/ask dealing spreads and considerably less little ability to absorb large transactions in comparison.

Figure #1 – This graphic shows the company logos of many of the major forex market liquidity providers that actively make markets in a variety of forex currency pairs to their professional counterparties and clients. Using intraday data, the authors demonstrate that contrary to widely held perceptions about the liquidity of the foreign exchange market, the market could actually be extremely illiquid. Furthermore, they find a strong commonality in liquidity trends across various currencies, with equity and bond markets limiting the diversification potential. As for carry trade returns, it is possible that this liquidity risk is to some extent priced into their returns. Unlike the stock exchange, which has a centralized location, the forex market is not centralized. Instead, the forex market is comprised of thousands of banks, brokers and traders transacting with each other but tracking volume independently of one another.

To be a successful trader, it is important to manage the risk and the volatility. Getting a grasp of these two factors starts with understanding liquidity. Liquidity affects market volatility and, although, volatility can be a friend or foe, a certain level of volatility is necessary for trading opportunities. Banks are usually involved in both large quantities of speculative trading and also daily commercial turnover. More importantly they are willing to take the other side of a trade during a volatile trading period, thereby allowing small speculators to manage their risk more efficiently.

Liquid Markets

It would be insightful and add to the robustness of the findings if the period of study were extended to analyze whether similar trends are observable in other time periods. Large stock markets, such as the New York Stock Exchange, are also considered highly liquid because thousands of shares change hands every day. But the liquidity of an individual stock can vary depending on factors such as its market capitalization, the exchange its shares are traded on and whether it is included on an index. Usually blue-chip stocks such as Microsoft, Google and Apple will be extremely liquid. Unless a retail Forex broker has high capital reserves, it cannot trade with the major liquidity providers and have access to all of the perks including tight spreads that comes with having huge amounts of capital.

If there are only a few market participants, trading infrequently then liquidity is considered to be “low”. One example of this is a comparison of assets with and without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like the difference between newly issued U.S. Treasury bonds compared to off the run treasuries with the same term to maturity.

Generally, when using these formulas, a ratio greater than one is desirable. Adam Hayes is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7 & 63 licenses. He currently researches and teaches at the Hebrew University in Jerusalem.

The major commercial bank liquidity providers include Citibank, Deutsche Bank, Societe Generale, Union Bank of Switzerland and HSBC. Without liquidity, the activity would be chaotic, highlighted by jumps and gaps in prices. A highly liquid market, however, creates a smooth entry and exit transition, making it desirable for all of the players in the market to participate from small speculators to large institutions. The Forex market is the single largest market in the world not just in terms of average daily turnover and average revenue per trader but also the largest market in terms of participants. Furthermore, caution must be observed when using leverage because the risk inherent in any market is that much greater with increased leverage, and so your trading account could be wiped out in just one sharp forex move.

Theory and empirical evidence suggests that investors require higher return on assets with lower market liquidity to compensate them for the higher cost of trading these assets. That is, for an asset with given cash flow, the higher its market liquidity, the higher its price and the lower is its expected return. In addition, risk-averse investors require higher expected return if the asset’s market-liquidity risk is greater. This risk involves the exposure of the asset return to shocks in overall market liquidity, the exposure of the asset’s own liquidity to shocks in market liquidity and the effect of market return on the asset’s own liquidity. Here too, the higher the liquidity risk, the higher the expected return on the asset or the lower is its price. Central Banks – the national banks that usually also issue their country’s currency sometimes intervene in the foreign exchange markets to stabilize their currency.

Rather than paying the indirect cost of waiting until finding someone who will pay us the full $100 of cash, we may choose instead to cut our waiting time to zero and simply pay someone else, a “dealer,” to do the waiting for us. The value of an investment in stocks and shares can fall as well as rise, so you may get back less than you invested. Many new cryptocurrencies have been launched, but most of them have disappeared because of low interest among investors.

However, when the Forex market is highly liquid, the market becomes less volatile, wherein the currency pair prices do not fluctuate as much and are considered stable and risk-free. Other examples of illiquid assets include real estate, some forex pairs – especially emerging FX pairs and exotic pairs – and smaller cryptocurrencies. In a liquid market it is easy to execute a trade execute a trade quickly because there are numerous buyers and sellers. For instance, with a daily trading volume of over $5 trillion, forex is considered the largest and most liquid market in the world. Algorithmic Traders – High-frequency algorithmic traders or Algo traders have managed to change the landscape of Forex CFD trading.

Author: Daniela Sabin Hathorn