Liquidity and Volatility in Forex
Liquidity and volatility have a great impact on each other in forex. A high level of liquidity leads to a low level of volatility because of lesser fluctuation in prices and vice versa. Since the foreign exchange market ranks as one of the most liquid markets on the planet, it is not overly volatile. Yet, this should not be mistaken for an absence of volatility. Volatility does occur in the forex market on a regular basis as the prices of currency pairs change almost every day.
Understand that not all currency pairs are the same in the forex market. The two major factors that tend to distinguish the behavior of currency pairs are the level of liquidity and volatility. Some currency pairs can be more liquid and less volatile while others can be more volatile and less liquid. Getting a good grasp of the relationship between liquidity and volatility will enable forex traders to develop a solid trading strategy. The more traders grow in the forex market, the better they can refine their trading strategies for better results.
Let us now examine liquidity and volatility so that we can understand their importance in the forex market.
Liquidity in Forex
Liquidity is generally defined as the closeness of an asset or market to cash. For instance, a house is an illiquid asset due to its level of separation from cash. It involves looking for a buyer, negotiating, and closing the deal before exchanging the asset for cash value. It is a whole process that consumes time while posing more risks to the holder of the asset.
However, the forex market is different as the assets (foreign currencies) are literally cash which is why it has one of the highest levels of liquidity. Also, there are significant incentives for the monitoring of international monetary supplies regarding geopolitical and economic movements. Furthermore, the impact of various traders with varying needs makes it possible to achieve market prices that are realistic and rational.
By definition, liquidity in forex refers to the ability of a currency pair to be bought and sold in the forex market without a significant impact on its exchange rate. So, when a currency can be bought and sold easily without much fluctuation in its exchange rate, it is a liquid currency. With liquidity in forex, the level is determined by whether a currency pair is a major, minor, or exotic pair (including emerging market currencies). The liquidity drops from high to low as traders move from major pairs to minor pairs and then to exotic pairs. This means that the most liquid is the major currency pairs while the least liquid is the exotic currency pairs.
High liquidity in forex denotes a currency pair that traders can buy or sell in substantial quantities without significant variations in its exchange rate. This is the case with major currency pairs such as EUR/USD, USD/JPY, EUR/GBP, USD/CAD, GBP/USD, etc.
Low liquidity in forex denotes a currency pair that traders cannot buy or sell in substantial amounts without large variations in its price level (exchange rate). This occurs in exotic currency pairs such as PLN/JPY.
Factors responsible for liquidity in Forex
There are three major factors responsible for liquidity in forex and they are discussed below.
Expansion in a monetary policy
Any changes in the monetary policy of the world impact the foreign exchange rate and thus, the liquidity. If a country should choose to expand its monetary policy to increase its cash flow, this leads to an increase in incomes for the citizens. This will lead to the citizens having more money for investment thus increasing the liquidity of that country’s currency.
Increase in the supply of global credit
An increase in the global credit supply means that more loans are made available to people. When this happens, it has a positive effect on liquidity in forex. A higher credit supply will cause traders and investors to have more money in their hands. This group of people then invest in the forex market by purchasing currency pairs thus leading to higher liquidity in the market.
Decrease in the demand for global credit
A decrease in the demand for global credit implies that people already have sufficient money for trading and investing. As a result, they do not need more credit to invest in the forex market. This way, people can focus on investing thus leading to increased liquidity in the forex market.
But if the credit demand should increase globally, then it means people do not have sufficient money for trading or investments. In such a situation, it will mean less liquidity in the forex market.
Volatility in Forex
Volatility in forex refers to the frequency of change in the prices of a currency. In other words, it measures the frequency with which the market moves up and down. It is not only restricted to the number of times the market changes direction but the extent of those changes. A currency that experiences wider swings or more up and down movements has high volatility.
The higher the volatility of a currency, the higher the risk of trading that currency in the forex market. However, trading currencies with high volatility opens the trader up to potentially higher returns.
Volatility measures how far a market moves during a particular price cycle. This is why it is a representation of the markets with a broader cycle between their highs and lows. The opposite of volatile markets is stable markets because these tend to have narrower cycles. The gap between high and low prices in such markets is also small.
Markets with higher volatility tend to offer leveraged traders excellent opportunities to make significant profits in the shortest time possible. In this case, the larger the price swings, the higher the possibility of the market moving. This increases the chances of traders earning profits from their trades.
The forex market is generally less volatile because the driving factors behind prices are the governments and gigantic global banks. This is why most forex transactions tend to feature a high amount of leverage. The high leverage serves as a compensatory measure to ensure that traders maximize potential profits. Volatility increases as traders move from major currency pairs to minor pairs and then to exotic pairs. This means that the most volatile currency pairs are the exotic pairs while the least volatile are the major currency pairs.
Factors responsible for volatility in Forex
Similar to liquidity, three main factors drive volatility in forex and they are discussed below.
Economic shocks which affect demand and supply
A change in the taxation policy or an unexpected rise in the prices of oil can constitute economic shocks which can have an adverse effect on forex volatility. For instance, if a nation should impose heavy trade tariffs, it will have a negative impact on a large part of the population (consumers). This will lead to a reduction in the population’s percentage that can invest in the forex market. As a result, the prices of currency pairs drop which leads to volatility.
Also, if there should be a surge in oil prices across domestic economies due to excessive demand, this could cause the currencies of the gulf countries to rise. This is because they will be supplying increased quantities of oil while generating increased revenues. The overall action and reaction chain leads to higher volatility in forex as regards international currencies.
Global changes and occurrences
Various global changes and occurrences such as wars, political elections, natural disasters, and other similar events can affect forex volatility immensely. For instance, if a nation should have upcoming elections, most traders will be reluctant to invest in the currency of that nation. This is because a change in government is viewed as a change in the country’s political sentiments which can bring about volatility in the market.
Changes in the interest rate
Volatility in the forex market is affected when there are changes in the interest rate. When there is a rise in the interest rate of an economy, investors will be forced to reduce their spending. As a result, the price of the domestic currency will fall considerably thus leading to high volatility in the forex market.
But a falling interest rate will enhance the spending power of the populace since they will have more money available. This way, there will be an appreciation in the price of the domestic currency which causes high volatility in the market because of the price fluctuation.
The relationship between Liquidity and Volatility in Forex
There is a direct relationship between liquidity and volatility in forex. The level of liquidity in the forex market affects the market price which in turn determines the level of volatility. A low level of liquidity in the forex markets results in high volatility thus leading to rapid changes in prices. But when the liquidity is high, there is less volatility and as such, there are fewer fluctuations in the prices of currency pairs. They are thus seen as stable and with little risk.
Low volatility generally does not favor short-term traders since they are always looking to make profits over shorter periods of the market cycle. As a result, markets with low volatility have very few trading opportunities that short-term traders can capitalize on. This is why such markets are considered more appropriate for long-term investment. But then markets with low volatility are less likely to collapse.
To counterbalance the effect of subdued volatility in the forex markets, there are wide ranges of leverage that traders can employ for various transactions. As a consequence, smaller movements in the forex market count for so much more because the level of leverage used multiply the entire transaction. Thus, leverage compensates for the low level of volatility in the forex market.
In terms of liquidity, the forex market is unmatched. There is no other market on the planet with such an amount of liquidity. This means the forex market shows accurate market value with greater efficiency than any other market. Furthermore, there is a limited amount of disparities since there is not much delay and demand is abundant where trading positions are concerned.
With the involvement of various central banks, private institutions, and governments, there is no shortage of buyers and sellers in the forex market. As a consequence, prices in the markets are as accurate as possible. This holds a myriad of benefits for traders. Liquidity ensures fairness and accuracy in market prices. At the same time, liquidity makes it possible for traders to open and close positions virtually in an instant. Unlike other markets where there might be a period of delay between instruction and execution of transactions, that does not happen in forex. This is because the forex market contains many participants and a high trading volume which ensures the completion of transactions within a fraction of the time.
The liquidity in the forex market is due to currencies being the embodiment of liquid assets. Also, there are various alternative players involved that can fulfill supply and provide demand across the markets including alternative currency pairings. Furthermore, the availability of leverage amounts on margins as low as 0.2% enables the market to feature massive liquidity and a high volume of trading that is always flowing. This liquidity in forex makes it attractive to various kinds of traders. It enables trading in purely liquid assets with the potential for significant returns which has increased its popularity.
Traders must understand the forex market before investing in volatile currencies to make profits. However, if the trader is just starting, it is more advisable to invest in currencies with high liquidity and low volatility since the risk involved is lesser while they still offer sizeable profits. Traders should also stay on top of regular updates so that they are aware of the factors that are likely to impact liquidity and volatility in forex. This information can then be used to set up and refine trading strategies that will enable the execution of successful trades in the market.