What is Forex Liquidity and Why is it important?

Source: Fazzaco 2020-08-13

The foreign exchange (forex) market is often described as the world’s most liquid financial market. “Liquidity” is one of the most talked about topics when it comes to currency trading.

What is Liquidity?

Let´s start with an example: if during an exam there are 30 people in a classroom, but there is only one pen, how long will it take the whole classroom to finish the exam? There will be great demand for that pen since there are not enough pens to go around. In other words, we are experiencing a pen market with no pens!

Liquidity can be defined as the existing demand for a product or service. How fast can you sell your car and turn it into cash? How fast can you sell your designer watch? In the financial markets, when we refer to liquidity, we mean how easily or fast a specific instrument can be turned into cash, either in an electronic or physical form.

Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market.

High levels of liquidity arise when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller. If there are only a few market participants, trading infrequently, it is said to be an illiquid market or to have low liquidity.

Why is it important？

Liquidity in the Forex Market is very important and impacts everything from the bid-offer spread to trade execution, especially in the following two aspects:

First, It determines the ability for a currency pair to be traded or even sold on demand.

If you are trading a currency that is very liquid, this can come with its own fair share of benefits.

If you are trading on the availability of the market pair however then you need to base the liquidity on the financial institution. This will get you in or out of the trade or even out of the currency pair that you are choosing.

It is important to know that not all currency pairs are liquid. Currencies have a varying amount of liquidity depending on whether they are exotic, minor or even major.

Second, An asset’s liquidity is also a key factor in determining the spread that a leveraged trading provider.

High liquidity means that there are a large number of orders to buy and sell in the underlying market. This increases the probability that the highest price any buyer is prepared to pay and the lowest price any seller is happy to accept will move closer together. In other words, the bid-offer spread will tighten.

(Source: Fxleaders, IG and Dailyfx)

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What is Forex Liquidity and Why is it important?

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