Liquidity in the Forex Market – How Does it Work?

The overall volume of trading and the amount of active traders in a market at any given time is called liquidity. When it comes to the foreign exchange market it is sometimes described as the most liquid financial market in the world, and the liquidity conditions of the Forex market are something that all currency traders need to be aware of.

 

The volatility with which prices move determines the amount of liquidity. In a market with a lot of liquidity prices change gradually and trends develop incrementally. As liquidity decreases, price changes occur quickly and in bigger price increments. Liquidity in the Forex market is constantly changing in response to such factors as which financial centers are open or closed and in what time zones.

For example, there is often reduced liquidity during periods dominated by the Asian sessions. However if there are major developments coming out of Japan the reverse may be true, in part because there is less happening elsewhere to offset any existing market trends. Generally the fewer number of traders and market interest there is, the more persistent the already existing trends may be. The Forex market is often at peak liquidity during the times when the London and European markets are open, sometimes called “the New York afternoon market.”

Factors that Cause Liquidity
The causes of liquidity are as diverse as the Forex market itself. Major news reports, economic announcements, political events, and just plain rumors can cause shifts in liquidity. Holidays and other seasonal events that have an economic impact can also affect liquidity. Reactions to market factors tend to be more abrupt during periods of reduced liquidity and slower during higher liquidity conditions. However, as is so often the case in Forex trading, there are no hard and fast rules of what the effect of any particular factor will be. Yet few would argue that when liquidity is thin, your exposure to risk is probably higher.

Different kinds of traders are influenced by liquidity in different ways. Hedge fund speculators tend to become more aggressive during periods of reduced volatility, which can push other participants in the market to react similarly and result in a major acceleration or reversal of breakout trends. That is why it is important to check market liquidity on a regular basis so you don’t miss out on price shifts that can be useful, or avoid those that are not.