Liquidity is one of the main reasons why the majority of investors prefer trading. The market offers trillions of traded volumes to benefit from. Liquidity is the factor that makes this particular sector extremely popular and promising in terms of potential returns.
On the other hand, certain variances are necessary to be taken into account. Liquidity purposes do not always guarantee success when establishing day trading. What’s more, it can be different depending on specific market conditions.
In this article, we will discuss the main idea behind market liquidity. We will explain certain liquidity risks as well as fundamental factors to let you understand why it is so important when trading currencies.
If considering the liquidity definition, it can be explained as the currency’s ability to be purchased or sold on demand. Let’s say, you are trading one of the major currency pairs. It means you are entering the market with exceeding liquidity. At the same time, each of your trades is dependent on the liquidity provided by financial institutions making it possible for you to get out or into the trade.
Traders should always keep in mind that NOT ALL currency pairs offer enough liquidity. In reality, different currencies come with varying liquidity levels. This is what makes different strategies kind of tricky. As you know, all currency pairs are divided into three major categories:
As you move further from major currency pairs to minor or exotic ones, you will watch the liquidity drying off.
When we say “high liquidity” about a currency pair, we mean that it can be purchased or sold in huge volumes without detriment to an overall exchange rate.
Oppositely to the previous one, low liquidity depicts a currency that cannot be traded in significant sizes. Besides, it generally comes with little or no variances in the price level or exchange rate, which makes it pointless for traders, as they are unlikely to profit from the rapid price change.
When looking at the market from a professional point of view, illiquidity is often associated with chaotic gaps. It means the price can change direction unexpectedly and is very hard to predict. It results in a variance in buying and selling volume.
Oppositely, a liquid market is known for its smooth price action. Liquidity means and deep and steady market with simpler options to manage risks. On the other hand, the chances of taking the wrong side or missing a big move in the illiquid market are much higher.
So, here are the 3 main factors every trader must always keep in mind:
Each of the above-mentioned factors will make it easier for traders to keep an eye on rapidly changing market liquidity and identify the best trading opportunities with either long or short positions.
As a trader, you must clearly realize a strong connection between rewards and risks in the financial market. The two factors are proportional. In simpler words, the higher risks you take, the higher your potential rewards. The best way to manage liquidity risks is to lower the leverage. Another handy option is to set stop-loss orders or so-called guaranteed stops. They mean a broker is obliged to honor a stop price level you have indicated.
Beginner traders often overlook the options hidden between the reward and risks of liquidity. In real life, they form a major part of professional traders’ routine when performing market analysis or defining future price actions.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.