Why Is Market Liquidity So Important?

Liquidity drastically affects the volatility, volume and cost of trading, so it's an important consideration.
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We have Lianca asking a little bit more information about market liquidity. Why it’s important and how to use it in our trading? Now, as always, thanks for the question, Lianca.

Now, liquidity of an instrument, you know, is simply the amount of all the willing buyers and the willing sellers, or let’s say, you know, the active participants that’s actively trading that particularly instrument. So, the more traders who invest that are actively trading something, the higher it’s liquidity will be. And that’s why liquidity has a direct impact on the volatility as well.

So the moment when there are low liquidity, when there’s low liquidity it means that there’s gonna be fewer participants trading that instrument, which means there are less counter orders in the market. Which, in turn, means that small catalysts can actually cause very exacerbated moves. And fast moves in price.

So, the liquidity will basically vary between currencies and currency pairs and those which are less liquid will typically have greater volatility and thus higher, bigger daily moves. Now for some traders, the idea of greater or more volatility is better and it’s very alluring, because the idea, of course, is that you can make more money from the moves.

But remember, now whether you’re trading a low or a high volatility pair, you’re always gonna keep your leverage in check, to protect your account.

So just because it’s a high liquidity it might move faster, but it doesn’t mean that you should risk more on that particular trade, right? You should actually risk less and the more volatile a particular instrument is. Another, you know, thing why volatility and liquidity matters, is, of course, the cost of trading.

So the higher the liquidity of a particular currency or pair is, the more stable that volatility is. It usually means that, you know, you’ll get more attractive spreads and commissions, so think of something like the Euro versus the US Dollar. It’s the most liquid currency pair in the world. So you often get very, very tight spreads and commissions on it.

Now, if you compare that to something like, let’s say, the USD ZAR, for example, which is a lot more eliquid, or let’s say rather the Euro ZAR, you know, the volatility and the eliquidity will mean that your spreads and your commissions can sometimes get out of hand for those particular currency pairs.

Now, a currency and, you know, it’s related pairs isn’t only affected by just the liquidity itself, but the liquidity can also be affected by the time of day. So, a currency is usually the most liquid during the time when that specific country is trading. So when they have their normal trading hours.

So that is why you normally have your Aussie dollar and your Kiwi dollar and also your Japanese Yen, usually they’ll have more liquidity during the Asia back session and something like the Euro or the Pound will be most liquid during the London session.

But, you know, please keep in mind that the overall session liquidity is also very important because it rates. So the bulk of trading, the bulk of the day’s trading volume usually goes through the London trading session, followed by the New York trading session and then followed after that by the Asia back session. So that means that even though the Aussie and the Kiwi might be more liquid during the Asia back session, the overall thinner liquidity in volume can still cause exacerbated moves in those currencies during that particular Asia back session.

The other challenge that come into play with the thinner liquidity and lower volume during those times, is slippage, right. So, during those times of, that time of the day, there’s going to be a much greater risk of slippage when the volume is low and the market moves are likely to be more exacerbated by it as we said and more volatile if we do get a very important catalyst.

Other liquidity considerations are things like bank holidays, right. So, if you have a bank holiday coming up, obviously there’s gonna be much less market participants so you might see thinner liquidity, higher volatility and, of course, that can also push up your costs. And that can also, you know, see more exacerbated moves across the market.

Also keep in mind there’s what we call that mid-year slump, which is between July and August. Lot’s of traders away on holiday. During those periods, you know, markets are usually fairly quiet, but due to the reduced volume and reduced participation, if there are any surprise market developments, market moves are once again likely to be more exacerbated, more exaggerated and volatile.

And if there’s no significant news, the market might just be flat, you know, very muted and very lack less. So very important times we need to consider in terms of liquidity.

Now, knowing this will allow us to, of course, better risk manage our trades and potential trades that we want to take, you know, know the risks involved. If you’re trading, for example, over the Christmas period, know that it’s not the ideal market environment that you want to be trading in. Always gonna be greater risk of slippage. Greater risk of bigger than usual movements due to volatility.

So, definitely a couple of factors to keep in mind for liquidity. So, Lianca, I hope that helps with your question. Any other questions about liquidity, don’t hesitate to let us know.

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