Liquidity in the Forex Marketadmin 18 October 2021
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Liquidity refers to the speed at which a particular asset can be bought and sold in a market without affecting the price. The liquidity of an asset is very important to traders because it can directly affect their activities and decisions in a market. Assessing an asset’s liquidity helps traders know how long it takes them to access a market and profit from trading it.
What is a liquid asset?
Liquid assets are the ones that you can trade in a short period in market working hours without reducing their value to make them look valuable or attractive to buyers. Liquid assets always have many sellers and buyers in the market, and you can identify them based on this fact.
Some may say this definition is somehow similar to the definition of market depth. In market depth, the quantity and price of traded assets matter most, but the required time to buy and sell an asset is the important factor in liquidity.
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The assets that are difficult to sell without price reduction are illiquid assets. The illiquidity of an asset may have some reasons, such as lack of market interest or uncertainty of traders about an asset in a specific situation. The most liquid assets in financial markets are currencies. Real estate, on the other hand, is one of the most illiquid assets.
Different currency pairs based on their liquidity in the Forex market
The most important factor for categorizing currency pairs is their liquidity level. Considering the liquidity of various currency pairs, we can divide them into 3 main categories: Major, minor, and exotics. Major currency pairs are the popular ones that most traders use every day. They are incredibly liquid, and you can trade them quickly whenever you want. Each currency pair involves two distinct currencies, and the major ones involve the most popular currencies.
The U.S Dollar (USD), the British pound (GBP), the Japanese Yen (JPY), and Euro (EUR) are some of the popular currencies in the Forex market. The currency pairs that do not involve the U.S dollar are the Minor currency pairs, and they are usually less liquid than the major ones. In addition, the illiquid currency pairs that are not popular among traders are the exotics; For example, the Turkish Lira and Mexican Peso.
The effects of liquidity on trading in the Forex market
Most traders prefer to use major or minor currency pairs because trading them is easier and they usually have low spreads. Trading exotic currency pairs are really challenging for most traders because they have high spreads and low liquidity. It is usually recommended that you trade the exotics if you are experienced enough or sure about making a good profit.
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As we said earlier, liquid assets have many buyers and sellers. It makes them easy to trade because there are always many buyers and sellers in the market, and you can easily trade them in the shortest possible time. Also, selling liquid assets does not have a considerable effect on their prices. When an asset is illiquid, you may have to keep your position open for a long time to find a buyer. Therefore, the more liquid an asset, the better it is for trading.
Measuring the liquidity in the Forex market
There are several ways to identify the liquidity level of a currency pair, but the easiest and quickest one is to look at the ask-bid price. The smaller the spread, the more liquid a currency pair is. In the past, traders used trading volume to identify the liquidity level of a currency pair. However, it turned out to be the wrong method because the high trading volume does not always indicate the high liquidity of the currency pair.
The risks linked to liquidity
There are two types of liquidity risk in the markets that you should be aware of them. The first one is cash flow risk. This risk involves companies. It refers to the risk of falling short by inappropriate cash flow management practices. The lower the cash flow, the better a company can use its working capital effectively. Companies can avoid it by using different funding methods.
The second one is market liquidity risk. Traders expose this risk when they are not able to exit an open position. Real estate is the market with the highest amount of liquidity risk. Sometimes due to different situations selling a property can be impossible. Therefore, drastically reducing the price of a property can be the only way to make it attractive to buyers.
Now that you know a lot of details about liquidity, you can find the best currency pairs to trade in the forex market. Trading illiquid currency pairs can lead to big losses. So, if you are a beginner in the forex market, you should only go for the major ones with a high liquidity level. DeltaFX broker offers you all of the major currency pairs with competitive spreads. Open an account right now and make your first trade.