How often do you hear the word liquidity? Since you set foot in the forex world, of course the term liquidity has become more common. In general, liquidity is a company's ability to pay its short-term debts such as tax debts, trade debts, and the like. But interestingly, liquidity is not just a common term in the business world.

The term liquidity also exists in forex trading. A person, company or even a country can gain huge profits when they have investment assets with high liquidity. However, these assets can also bankrupt them if they are not placed and managed properly.

High liquidity can bring high profits. But make no mistake, profit and risk in any financial market are almost proportional. In other words, the higher the profit, the higher the risk.

How do we prepare for this? Understanding what liquidity is and the relationship between liquidity risk and profit in forex trading is very important. These things are useful for minimizing risk opportunities and increasing profit potential.

What is Liquidity? Why is it Important?

Before understanding what liquidity is, it is better if we take an example of an event. There are 10 people waiting for a taxi in one place at night in the middle of very heavy rain. At that time, 1 taxi appeared that stopped in the middle of the road and was probably the last taxi operating that day. Maybe we can imagine how great the need for taxis was at that time and automatically the higher the offer to the taxi driver.

This is more or less what happens in a forex market. In the world of forex markets, liquidity is what happens when an investment instrument can be exchanged for cash. The faster and easier it is to exchange, the greater the liquidity of the instrument. What happens in the forex market, not all currency pairs have the same liquidity. Currency pairs are divided into 3 types: major, minor and exotic.

Major types are the most frequently traded pairs globally. High liquidity makes them easy to trade virtually. Some of the majors include EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD. Each pair has the US dollar as one of the pairs. This is because the US dollar is involved in 88% of the world's currency exchanges.

Minor currency types are pairs that do not involve the US dollar. Some of them are EUR/GBP, EUR/AUD, GBP/JPY, CHF/JPY, NZD/JPY, and GBP/CAD. The most frequently involved minor currency pairs are the euro, yen, and pound sterling.

Exotic currency types are pairs that involve a major currency with a currency from a developing country. Exotic pairs are not as numerous as major or minor pairs because these currency pairs tend to have low liquidity. One example of a currency pair that falls into the exotic category is PLN/JPY.

Forex liquidity can gradually decrease as traders move from minor to exotic currency pairs. High liquidity in the market refers to the ability of a currency to be traded in significant amounts without much difference in its exchange rate.

Signs of a Liquid or Less Liquid Market

A less liquid market will experience uncertain movements and gaps because the level of buying and selling volume in one period can be very different. A market with high liquidity has very neat price movements so it is often referred to as a smooth market.

Traders often need and require a market with high liquidity to help them manage trading risks. So, when traders go in the wrong direction or there is a big movement, at least traders can minimize losses. There are several signs that we can use to identify whether the market is liquid or less liquid.

  • Gaps in Forex Trading

Forex gaps vary widely compared to other markets. However, gaps can occur when interest rate changes or major news announcements cause market conditions to be less than expected.

Gaps often occur on the opening day of the week on Sunday afternoons in the United States. If there is major news over the weekend, the overall average gap in forex is usually less than 0.50% of the currency value. Any market that is traded 24 hours a day tends to have higher liquidity or tends to have low gaps because transactions are running throughout the day.

This allows traders to open/close the market as they wish. In contrast, markets that are traded for half a day, such as the stock market, can have very large gaps, especially when major news occurs.

  • Forex Liquidity Indicator

Brokers often offer a ‘volume’ option where traders can gauge market liquidity. This forex liquidity indicator is presented by analyzing the bars in a volume table. Each volume bar represents the volume of transactions that occurred within a certain time period, giving traders a more accurate estimate of liquidity.

It is important to remember that most brokers only provide their own liquidity data and not the overall forex market average. However, broker liquidity data actually reflects market conditions. The data provided is sufficient to represent several markets depending on the scale of the brokerage firm.

  • Liquidity Always Differs in Each Time Zone

Short-term traders or scalpers should be aware of how liquidity in forex can change simply because of different time zones. The Asian, European and American sessions, which are the major sessions when the market is active, will affect the liquidity of a particular market.

The biggest moves often occur during the morning American Session, which is also when the European Session is in progress. This is because these 2 sessions account for more than 50% of global trading volume.

Relationship between Liquidity Risk and Profit in Forex Trading

The relationship between risk and profit in financial markets is almost always proportional. In other words, it is very important to understand the risks that will occur in a transaction. A simple example of liquidity risk in the forex market is when the Swiss Franc crisis occurred in 2015.

The Swiss bank announced that it would no longer peg the franc to the euro, causing the interbank market to collapse due to its inability to maintain market prices. This made it difficult for brokers to offer liquidity in CHF. When interbank prices reopened, EUR/CHF was far from its previous price. This had a major impact on the accounts of traders using CHF.

Although it is rare, it is not impossible for it to happen. That is why traders must be able to manage liquidity risk by lowering the leverage level or utilizing the stop order feature. These two methods can keep traders away from the risk of drastically fluctuating liquidity.

Understanding the relationship between risk and liquidity profit in forex trading helps us determine safer markets so that we can build more stable profits and manage risks better.

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