How important is liquidity in the forex
In the foreign exchange market, understanding liquidity and volatility is crucial for investors, as liquidity refers to the level of trading activity and volatility is highly influenced by liquidity. If liquidity is too poor, it can lead to significant price fluctuations, making it difficult for investors to manage risks.
What is liquidity, and why is it important?
Liquidity can be used to observe the level of activity in the foreign exchange market, specifically how many buy and sell orders are actively traded.
The foreign exchange market is a 24-hour trading market, with a daily trading volume of nearly $6 trillion, making it one of the most liquid markets in the world.
However, it is worth noting that not all currency pairs have excellent liquidity in the foreign exchange market. In fact, currency pairs often have varying degrees of liquidity depending on whether they are major, minor, or exotic currency pairs. Liquidity decreases in the order of major currency pairs -> minor currency pairs -> exotic currency pairs.
What are the major currency pairs with the "best" liquidity?
EURUSD
The euro against the US dollar is the most actively traded currency pair in the foreign exchange market due to the eurozone and the US being the two largest economies globally.
Due to the enormous trading volume of the EURUSD currency pair, it also has high liquidity, making its volatility usually lower than other currency pairs. However, even the most liquid instruments can experience significant price swings under certain conditions, such as the outbreak of the Covid-19 pandemic in March 2020, when the Fed implemented zero interest rates and unlimited QE, causing the EURUSD to surge instantaneously, one of the high volatility scenarios.
USDJPY
The US dollar against the Japanese yen is the second most traded currency pair in the foreign exchange market, second only to the EURUSD.
The USDJPY currency pair also has high liquidity because during periods of economic uncertainty or financial market turmoil globally, the Japanese yen is widely regarded as a "safe-haven currency." Thus, market funds are easy to flow into buying the Japanese yen, often resulting in a significant increase in trading volume of the USDJPY currency pair.
GBPUSD
The British pound against the US dollar currency pair is also known as "Cable" because GBPUSD was the first currency pair to be traded via transatlantic communication cables.
The UK and the US are two major Western economies with close trade relations, making the trading volume of GBPUSD also massive.
What are the "lowest" liquidity exotic currency pairs?
Exotic currency pairs usually have the lowest liquidity, such as the Polish zloty against the Japanese yen.
As the economic trade volume between Poland and Japan itself is not high, the delivery demand or hedging risk demand of the two currencies is relatively small. Therefore, exotic currency pairs usually have low liquidity.
Does the liquidity of the forex market vary during different trading sessions throughout the day?
In daily forex trading, there are periods of low activity, such as during the Asian session when prices tend to consolidate. However, during the London and US sessions, prices are more likely to experience significant fluctuations.
Among the trading sessions throughout the day, the US morning session has the best liquidity, as it overlaps with trading hours in Europe and London. The forex trading volume during the European and London trading sessions accounts for over 50% of the daily global trading volume, with the overlapping period with the US morning session accounting for approximately 20% of the total daily trading volume.
The volatility of forex is directly influenced by liquidity.
Liquidity has a significant direct impact on market price volatility in all financial markets, including the forex market. High liquidity markets have higher trading volumes and therefore lower volatility, resulting in more stable commodity prices. In contrast, low liquidity markets have lower trading volumes, higher volatility, and commodity prices are more likely to experience significant fluctuations.
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