What is Liquidity in Forex?

Imagine a series of stalls in a market, where every one of them sells pencils at similar prices. Each stall, which is normally filled with customers, offers a variety of pencils of different qualities. This is a good market for pencil vendors, who can be sure of getting fair prices for their wares when they’re sold there. It’s also a good market for consumers, since they can probably get a decent pencil without overpaying. (This wouldn’t be the case in a market with only three stalls, each offering pencils at wildly different prices.) The word we would use to describe such a market is “liquid”, which implies trades can be made fairly and quickly.

Turning now to a different marketplace – the global forex market – we see it is also highly liquid. Practically, this means that someone who wants to sell $5 million worth of the GBP/USD currency pair can do so without much delay, while benefiting from a tight spread and without impacting market prices. A tight spread implies there is little difference between the highest price someone will pay to buy a lot of GBP/USD (bid price) and the lowest price someone will accept to sell one (ask price). This is desirable for sellers in the market because, like the pencil vendors in our example above, they don’t have to sacrifice unrealized gains in their assets in order to sell them. From the buyers’ perspective too, there’s no need to pay much more than the fair value of the currency pair. Thus, the high liquidity of the forex market consistently attracts hopeful participants from all parts of the globe.

There’s no more liquid market than the forex market, largely because it sees trading volume of up to $7.5 billion every single day, which makes the equity and bond markets pale in comparison. Aside from trading volume (which measures the dollar amount changing hands daily for an asset), there’s also the fact that forex is traded 24 hours-a-day every weekday (since the market follows the business hours of three main sections of the globe). With people in Asia, Europe, and the United States constantly trading currencies throughout the day, this also contributes to the market’s high liquidity levels.

However, trading volume is not identical to market liquidity. And, although high liquidity implies the ability to trade without affecting prices, this does not mean that liquid markets are devoid of volatility. Let’s find out why by homing in on that elusive liquidity meaning.

What is Liquidity in Trading?

Those who trade stocks know that the spreads between the bid and ask prices are usually quite reasonable. This is due to the fact that stock markets have high liquidity levels. In fact, if you see the spread for a particular share tightens, it means the market has become more liquid. Vice versa, a widening gap between bid and ask prices suggests the market has lost liquidity.

Most of the time, you can spot a liquid stock by its high trading volumes, which reach into the hundreds of millions of dollars. However, as we mentioned, there are factors besides volume that determine liquidity for an asset. The most prominent among them is order book depth, which reflects the number of pending orders for that asset at the moment. As the trading day progresses and orders are filled or cancelled, the order book is constantly updated.

What is liquidity in forex? In the forex market, you might find an order book for the USD/JPY pair that looks something like this: 2.75 million buy orders at the price of 145.20; 3 million buy orders at 145.19; 3.25 million at 145.18, and so on. The bid price (highest buy offer) is currently 145.20. The ask price (lowest sell offer) is 145.21, making for a one-pip spread. This order book has depth, as evidenced by the narrow spread of only a single pip. What gives it depth is the fact that there are plenty of orders waiting at various price levels, which means the market is able to absorb many large orders without causing a shift in prices.

Liquidity and spreads might be correlated, but they’re not exactly proportional. Take the case where you have a thin order book for the USD/JPY, but the spread is still only one pip. Since there aren’t too many orders waiting on the books, this market is illiquid and would respond to a large order by adjusting prices. Here, the narrow spread doesn’t imply high liquidity.

What is Liquidity and Volume in Trading?

We have said that, oftentimes, the most liquid assets display the highest trading volumes. But is there such a thing as a market with high trading volume but low liquidity? Imagine the following case: In the middle of the New York forex trading session, the Bank of Japan suddenly intervenes in the market by strengthening the yen, knocking the USD/JPY into a precipitous fall from 149.00 to 144.50 in only minutes. Trading volume shoots up dramatically, as traders rush in to close long positions and open short positions on the pair. However, the order book remains thin because market makers withdraw their quotes out of uncertainty. Liquidity dries up and the spread between bid and ask prices widens. High trading volume didn’t succeed in liquifying the market, leaving it unkempt and chaotic.

What about the other way around – low volume but high liquidity? This too is possible. Take the case where trading is slow on the USD/JPY near the beginning of the Tokyo session. Despite the low trading volume, there is still order book depth – meaning there are plenty of orders for the pair waiting at various price levels. As a result, this market can endure a $5 million buy order without needing to shift prices around. In other words, it is a liquid market.

Price Volatility and Market Liquidity in Forex Trading

If liquid markets can absorb large trades without budging prices, how is it that the most liquid times in the forex market are characterized by the highest price volatility? For instance, the overlap of the New York and London trading session between 8 a.m. and 12 p.m. draws the heaviest trading volumes (and, with them, the highest liquidity) due to the heightened opportunity for financial gains. This opportunity is due to the fact that prices tend to move quite markedly – meaning that prices are volatile. Volatile price movements in the forex market draw in more participants because, when traders open deals in the right direction, there’s a stronger possibility of reaping solid earnings.

Here, the elevated liquidity levels in the market do not have a taming effect on prices. The reason is that a very liquid market can co-exist with high price volatility. The root cause of the volatility in the EUR/USD in the overlap period has nothing to do with a lack of liquidity. It’s driven by the high trading volume, which moves prices through the force of group consensus. Key economic announcements in this time period also fuel that volatility. But the market is still liquid: Any participant could quickly and efficiently execute a large trade in the pair without leaving a mark on price levels.

Liquidity Meaning – A Conclusion

To sum up: Liquidity reflects the ability of a market to meet new orders in a timely and fair fashion without disturbing prices. A liquid market itself could exhibit high price volatility, which just means that bid and ask prices are changing rapidly.