The importance of foreign exchange trading liquidity

What is liquidity? Why is it important?
By definition, liquidity in the foreign exchange market refers to the ability of money to trade (buy/sell) on demand. When you trade major currency pairs, you trade a highly liquid market. However, your transactions are based on the available liquidity of financial institutions that can allow you to enter or exit transactions of your choice (currency pairs).
Not all currency pairs are highly liquid. In fact, currencies tend to have varying degrees of liquidity, depending on whether they are major, minor and exotic (including emerging market currencies). From major currency pairs to secondary currency pairs, and finally to foreign currency pairs, foreign exchange liquidity decreases in turn.
High liquidity:
High liquidity in foreign exchange refers to currency pairs that can be bought/sold in large quantities without causing significant changes in exchange rates/exchange rates, such as major currency pairs, such as the euro/dollar.
Other major (highly liquid) currency pairs to note:
£/$
USD/JPY
Euro/pound
AUD/USD
$/Canadian dollar
USD/CHF
NZD/USD
Low liquidity:
Low liquidity of foreign exchange means that currency pairs cannot be bought/sold on a large scale without causing large fluctuations in exchange rates, such as foreign currency pairs, such as Polish zloty/yen.
Foreign exchange liquidity and illiquidity: three signs to note
From the perspective of traders, there will be chaotic trends or gaps in a illiquid market, because the level of buying or selling at any one time may be very different. High liquidity markets are also known as deep markets or stable markets, and the price trend is also very stable. Most traders need and should require a highly liquid market, because in a less liquid market, it is difficult to manage risk if you choose the wrong side when a big market occurs.
Here are three signs to watch out for
1. Gap in foreign exchange trading
Compared with other markets, the gap of foreign exchange is different. However, if there is significant news of interest rate decisions announced or unexpected, there may be a price gap in the foreign exchange market.
On Sunday afternoon, U.S. time, when the weekly foreign exchange market opens, there may be a gap. If news is announced over the weekend, the overall gap in foreign exchange is usually less than 0.50% of a currency's value.
The following two charts describe the liquidity difference between the stock market and the foreign exchange market, which can be highlighted by the gap.
The stock market is prone to gaps: the FTSE 100 index
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There are few or no gaps in the currency market
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Markets that trade 24 hours a day, like the foreign exchange market, are considered highly liquid, or because of continuity, the gap is often smaller than the stock market. This allows traders to enter and exit the market at will. Markets like the U.S. stock market or futures exchange, which can trade only a small part of the day, are compressed into a smaller market, because prices can jump at the opening if overnight news is contrary to market expectations.
2. Foreign exchange liquidity indicators
Brokers often offer "volume" options on charts that allow traders to measure market liquidity. This measure of foreign exchange liquidity is explained by analyzing the bar graph on the trading volume chart.
Each trading volume bar represents the trading volume in a specific period of time, thus providing traders with an approximate indicator of appropriate liquidity. It is important to remember that most brokers reflect only their own trading volume data, not the liquidity of the entire foreign exchange market. However, using the volume of transactions of brokers as a measure can properly represent the liquidity of the retail market according to the size of brokers.
3. Liquidity is different at different times of the day
Short-term traders or scalpers should pay attention to the changes in foreign exchange liquidity during the trading day. In some less active periods, such as in Asia, the market is usually sideways, which means that from a speculative point of view, support and resistance are more likely to remain. Market periods with large fluctuations, such as London and the United States, are more prone to outbreaks or large percentage fluctuations.
You're likely to see the most volatile session of the day in early U.S. trading because it overlaps with the European/London session, which alone accounts for more than 50% of the world's total daily trading volume. The U.S. period alone accounts for about 20%, and in the U.S. afternoon, you often see prices plummet unless the Federal Open Market Committee (FOMC) makes a sudden statement, which is only a few times a year.
Liquidity risk vs rate of return
The relationship between risk and return in financial markets is almost always proportional, so we must consider understanding the risk in transactions.
A major example of liquidity risk in foreign exchange markets is the Swiss Franc crisis in 2015. The Swiss central bank announced that it would no longer stick to the franc's peg to the euro, causing the interbank market to fracture because it could not price. That has left brokers unable to provide liquidity in the Swiss franc. With the recovery of interbank pricing, the backbone of foreign exchange pricing, the euro/Swiss Franc price is far from the previous range. As a result, the balance of retail accounts that trade the Swiss Franc has been greatly affected. Although these "black swan" events are rare, they are not impossible.
Retail foreign exchange traders need to manage these liquidity risks by reducing leverage or using guaranteed stop losses, and brokers are obliged to execute your stop loss orders.
The choice between liquidity risk and return should not be ignored and should be part of the daily analysis of traders.