Often described as the most liquid financial market in the world, the forex market is nevertheless still subject to variances in liquidity that traders need to monitor closely.
When ‘liquidity’ is referred to in reference to the forex market, it means the amount of market interest, active traders and the overall number of trades taking place in any given market at any particular time. As a trader, the level of liquidity is usually noticeable because it is responsible for how volatile the market is. A very liquid market will usually see smoother price moves as small incremental changes gradually amass, but when a market is less liquid, prices will move in a much more abrupt manner, with prices fluctuating in larger increments.
The level of liquidity of the forex market will vary throughout the day, with the timing of the opening and closing of various financial markets in different time zones around the world having a huge effect. The first signs of this occur with reduced liquidity during the periods when Asian trading is at its peak. This means that, at those times, information from Japan, for example, can have an impact that may seem disproportionate because the trading interest is not enough to counteract the effects of the news on the markets.
When the European markets such as London open, however, the overlap with the Asian market and the Northern American market means that this period sees peak liquidity, which doesn’t drop off until the European markets close again. This quiet period is often referred to as the New York afternoon market.
The effect of liquidity.
The periods of reduced liquidity often see the most dramatic fluctuations in prices in the forex market. Even unsubstantiated rumours or breaking news can have a much more dramatic impact on prices than they would at times when there is a little more liquidity. When the markets are not very liquid, price movements can be incredibly unpredictable, so these are the times when traders are most at risk. Maintaining a position in the foreign market during these periods can increase your exposure to the risks of volatile price action.
Other things which can affect liquidity.
There are other reasons for differing liquidity in the foreign exchange markets, such as holiday periods in the various markets around the world. At Christmas, liquidity reduces because of the limited activity in the European markets, and this is also true of the late summer period and Easter. Although the volatility of the forex market is minimised at this time because of a general inertia, some traders will take advantage of their ability to reverse trends and can often effect big changes on the markets by the time the holidays are over. It is for this reason that traders should always keep track of liquidity conditions to ensure that they are not being exposed to unforeseen risk, even when things are traditionally quiet.
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