What is Forex Liquidity?
Liquidity in Forex or any other market refers to how easily a market can absorb and match orders.
If a market has a lot of participants buying and selling big quantities, it is called liquid. In a liquid market, it is easy to transact, spreads are naturally low, and orders are executed quickly. Where a market has little trading and only few participants buying and selling low volumes, the opposite situations occur.
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Forex Liquidity: Why it Matters to Forex Traders
In a more liquid market it is easier and cheaper to buy and sell.
In the Forex market, currency pairs can be divided into three classifications: majors, minors, and exotics. Each class usually displays quite different degrees of liquidity, with the majors generally making up a vast majority of the Forex market by trading volume, followed by the minors, and lastly exotics. For example, the US Dollar is involved in approximately 80% of all Forex trades, while an exotic currency such as the Vietnamese Dong would be less than 1%. These differentials impact the effectiveness of trading strategies, risk management, and trading costs. Beginner traders should start trading with the most liquid currency pairs before advancing to more complex trading approaches for less liquid ones.
Which are the Most Liquid Forex Pairs and Crosses?
The liquidities of currencies fluctuate from day to day, but under normal conditions, the most liquid currencies are, in order beginning with the most liquid:
The US Dollar, by far the most important currency in the Forex market.
Euro
Japanese Yen
British Pound
Swiss Franc
Canadian Dollar
Australian Dollar
New Zealand Dollar
What Impacts Forex Liquidity?
Forex liquidity is not constant and changes throughout the various trading sessions at different times of the day, varrying currency by currency.
Forex traders can witness liquidity changes by looking at the spread or the difference between the bid and ask prices. Periods of higher liquidity result in tighter spreads and vice versa.
Two factors impacting Forex liquidity:
1. Supply and demand: Trading volumes impact Forex liquidity. The more traders buy and sell, the easier it is for financial institutions like banks and brokers to compete for and match orders, increasing liquidity and lowering spreads. Economic releases, central bank actions, and geopolitical events impact supply and demand.
2. The opening and closing of global financial centers: The Forex market operates 24/5, and the bulk of order flow is automated, with trade placement and portfolio management conducted by algorithmic trading solutions. Despite this process, the official opening and closing of global financial centers, usually gauged by stock market operating hours, do impact Forex liquidity. The London-New York overlap session usually displays the most notable surge, as London accounts for most Forex trading volumes, followed by New York.
Noteworthy:
- While Forex liquidity varies throughout the day, most currency pairs and crosses have sufficient liquidity for very swift order fulfilment around the clock.
Why Should Forex Traders Care About Liquidity?
Forex liquidity impacts trading costs and can influence the performances of trading strategies. Trading costs increase when liquidity drops, making a notable difference in the outcome of trading strategies. For example, scalpers require highly liquid assets for a profitable result, making illiquid assets unsuitable. Traders using one strategy across all currency pairs, even if fully automated, can create less profitable results than an optimized one, when varying liquidity is considered.
The Difference Between High Forex Liquidity and Low Forex Liquidity
Trading costs remain the primary difference between high and low liquidity, followed by the most appropriate trading strategies to deploy.
A trading cost example:
Competitively priced Forex brokers quote the EUR/USD with a raw spread of 0 pips in a commission-based account with a commission between $0.80 and $7.00 or between 0.4 pips and 0.7 pips in a commission-free alternative.
Therefore, a 1 standard lot in the EUR/USD costs between $0.80 and $7.00. Less liquid currency pairs can have spreads exceeding 2 pips, resulting in $20.00+ fees. A trader placing 1 lot in daily trades, which is reasonable for portfolios below $5,000, can save $15 per lot on average or earn $300 more monthly by trading during high liquidity and avoiding periods of low liquidity.
Depending on the Forex broker and its access to liquidity pools, trading low liquid currency pairs may result in requotes, especially during fast-moving markets, which is another reason select trading strategies, like scalping, must be applied to high liquidity assets.
Volatility can also increase notably in illiquid assets, where one large order can move the price action dramatically, causing a spike or gap.
How Can Forex Traders Spot Changes in Liquidity?
When volume decreases, spreads usually increase. The problem is that accurate volume data can be hard to obtain in Forex. Brokers offering level 2 data can give another insight into how liquidity may change, as they display volume alongside the bid and ask prices.
.jpg "Volume indicator on a EUR/USD chart in MT5")
Volume indicator on a EUR/USD chart in MT5
Examples of price action suggesting changes in liquidity are shown in the EUR/USD price chart above. Since the EUR/USD is a highly liquid currency pair, price action remains smooth despite liquidity changes. There are no price gaps, as brokers fill orders ongoing amid rapid price changes, given the activity of buyers and sellers at any given moment.
Currency pairs with less liquidity can show price gaps, especially during market-moving events. While minor currency pairs generally have sufficient liquidity, exotic currency pairs are prone to price gaps due to low volume.
Why are Non-Weekend Price Gaps Rare in Forex?
1. The primary reason non-weekend price gaps exist in the Forex market is its relatively high liquidity. The Forex market is the most liquid financial market in the world, with approximately $6.6 trillion traded daily. Therefore, brokers can easily match client orders with few exceptions, even during volatile trading conditions.
2. The secondary reason is the 24/5 operational status of the Forex market, allowing price action to move smoothly from one time zone and financial center to another one without creating price gaps. Equity trading hours are restricted, and many market-moving events occur pre-market or after-market, creating price pressures that materialize when the trading sessions open.
Gauging Retail Forex Liquidity with a Liquidity Indicator
Trading platforms like MT4, MT5, and cTrader have volume indicators, and volume impacts liquidity, so it can be used as a kind of liquidity indicator. They are available as chart-overlay indicators and come in several types.
A tick volume indicator, which MT4/MT5 displays inside the chart window. Traders may also add a volume indicator below the chart, which can assist in confirming breakouts and breakdowns, as well as display Forex liquidity trends.
 (1).jpg "Volume indicators and the Force Index in MT5")
Volume indicators and the Force Index in MT5
The Force Index indicator offers an indirect look at Forex liquidity, as it uses volume as part of its calculations. It is a next-generation technical indicator measuring buying and selling power, but its use of volume makes it a tool which can be used to identify liquidity and confirm trends.
- Any volume indicator only reflects the trading volumes of the broker and not the entire Forex market, which is not centralized.
- The data sample suffices to generate a valid enough reference point to gauge Forex liquidity if the broker has notable trading volumes but is less useful on smaller brokers’ platforms.
The Importance of Trading Times and Their Impact on Forex Liquidity
Despite the 24/5 operation of the Forex market, trading times impact volume, liquidity, and price action.
The US session is usually the next most liquid session after London, and the opening of the New York session, as it overlaps with the final few hours of the London session, usually creates the most liquid trading period. High-frequency traders, high-volume traders, and scalpers monitor those liquidity events closely.
- The Asian session presently accounts for lower trading volumes, less liquidity, and typically produces more range-bound markets that respect support and resistance levels established during the London session.
- The start of the Tokyo session adds the most liquidity during the Asian trading session.
- Traders should monitor the first and last trading hour of each equity trading session in global financial centers, where most of the trading action occurs.
- The first hour displays more trading volume than the last hour of each session with few exceptions.
How Does Forex Liquidity Impact Risk-Reward Ratio?
Risk and reward in financial markets usually increase or decrease proportionally. Many Forex traders aim for a 1:2 risk reward ratio, meaning they will risk half of what they seek to earn on a trade. For example, they will place a stop loss 20 pips below entry if the take profit target is 40 pips above. Many traders are unaware of the impact Forex liquidity has on the risk-reward ratio.
Another potential concern is a “black swan” liquidity event, like the 2015 EUR/CHF unpegging, which temporarily disrupted the interbank market, causing hundreds of millions of trading losses and several broker bankruptcies. Black Swans are of course rare but can have a devastating impact. Traders can best decrease liquidity risk via cross-asset, cross-broker diversification, and by not making overleveraged trades.
Final Thoughts
Liquidity is a factor which can make a difference in Forex trading, if the trader pays attention to it and understands that it can be predicted. Traders can make use of variations in liquidity in the following ways:
- Understanding that some currencies are far more liquid than others, so will have lower trading costs. This is especially important for day traders and scalpers who trade often, as spreads (affected strongly by liquidity) will have a big impact upon overall trading costs.
- Understanding that certain times of day usually produce much higher liquidity in Forex, most notably the London / New York overlap, the earlier London session, and the later New York session. Having Forex trades open during these hours gives the best chance of strong directional price movement and therefore trading profits.
- Be aware that liquidity can dry up just before major economic data or central bank releases, causing second-by-second price gaps, very wide spreads, and very volatile price movement.
- Liquidity is challenging to measure, but tick volume indicators, which can be applied to any price feed through major trading platforms such as MT4 or MT5, are probably the best measuring method. When tick volume is abnormally high, this can sometimes be used as a profitable entry or exit signal.
