What is liquidity and volatility in forex?

Liquidity and volatility are important terms in the forex industry. Understanding their importance is crucial as they are the foundation of how the market runs and also provide a basis for forex trading strategies.

The forex market is one of the most liquid markets, as there are a huge amount of trades made each day – according to BIS, over $7.5 trillion is traded OTC per day. Depending on the currency pair, the volatility will vary, but generally speaking, the more traded a currency pair, the less volatile it is.

We explain what liquidity and volatility are in terms of forex and how it affects the forex market, as well as the relationship between liquidity and volatility.

What is liquidity in forex?

In simple terms, liquidity in forex is how many traders there are of a particular currency pair, and therefore the amount of money (liquidity) being traded with those two currencies. For example, the most liquid currency pair is EUR/USD, which makes up almost 30% of the forex market.

The liquidity of a forex pair dictates how quickly the currencies can be bought or sold for one another, or in other words, how quickly a trader can enter and exit positions at their desired price. If someone wants to buy or sell EUR/USD, they can almost guarantee that they will be able to at any price. The higher the volume of traders, and the higher the demand for exchange between the two currencies, the higher the liquidity. 

This also means lower transaction costs. As the bid-ask spreads, (the difference between the highest price and the lowest price) are narrowed with greater liquidity, there is less risk for a broker, so therefore the transaction costs are much smaller.

What is volatility in forex?

In simple terms, volatility is a measurement of the variation in a trading price. In forex trading, the volatility measures the comparison of two currencies, and high volatility will mean a vast fluctuation in the price.

Volatility for the forex market is not necessarily bad, as while it does incur more risk and transaction costs, there is potentially more reward in a greater fluctuation. Some traders with a greater risk appetite may benefit greatly from currency pairs with lower liquidity.

What causes volatility in forex?

Volatility in forex is caused by a number of factors, often a combination, and sometimes unknown reasons. It can be influenced by various factors such as world economies either growing or shrinking, geopolitical events and central bank policy.

For example, if one currency, such as the euro, suddenly becomes unpredictable after a recession while the US dollar remains strong, this increases the volatility of the EUR/USD pair, as the difference between the two currencies has widened, and the certainty of the currency pair has been put into question.

Currency pairs with much fewer traders may suffer even more volatility, as if traders pull out or exit their positions, the market may tip significantly more.

How do liquidity and volatility affect each other?

Markets that are less liquid are generally more volatile, so a high liquidity pair is more likely to be less volatile.

The more traders that trade a currency pair, the greater the liquidity, and this usually results in greater market stability, as buyers and sellers are more assured of their prices. High liquidity pairs are attractive for traders, as they are safer and easier to base a trading strategy. In this way, liquidity can be a direct indicator of the volatility of a currency pair.

The daily trading volume of EUR/USD is approximately $831 billion per day, which means that even the actions of a central bank or large financial institution won’t be enough to shift the market too much.

Does high liquidity mean high volatility?

No, in fact, the opposite. Low liquidity contributes to high volatility, and vice versa. This is because the more buyers and sellers in a market (causing a higher liquidity) means that trades can go through more easily, and large trades won’t affect the market as much.

Is high liquidity good in forex?

This all depends on the trading style. High liquidity directly correlates to less volatility, so for a more risk-averse trading strategy, high liquidity is good.

However, for those with a greater risk appetite, a pair with lower liquidity may be more attractive. Pairs involving currencies from emerging markets, known as exotic pairs, are examples of forex pairs with lower liquidity that form the basis for effective trading strategies.

Some of the most popular exotic pairs:

• EUR/TRY
• USD/NOK
• USD/DKK
• USD/ZAR
• USD/SEK

All currencies can be traded with one another, but generally only the most traded pairs can form the foundation of an effective trading strategy. This is because the more obscure the currencies, the lower the liquidity (as less people are trading it), and therefore the greater the risk and transaction costs. Plus, it may be more difficult to find a buyer in time if you are trying to exit a position quickly.

The role of liquidity providers in forex

Liquidity in markets can be provided as a service, and this is where liquidity providers come in.

To keep liquidity high, liquidity providers offer a way to inject liquidity into the market for financial institutions which can help narrow the bid-ask spread, decrease volatility, and generally create more favourable conditions for brokers or exchanges.

The forex market is kept liquid by huge investments from central banks and financial institutions which act as market makers. Market makers are also available at any level of the market and provide access to liquidity which smooths out market volatility.

Conclusion

Forex liquidity and volatility are a key part of the global forex market, and liquidity providers are key players in keeping the volatility of the market in check.

LiquidityFinder provides you with a wide range of options for your liquidity needs in the forex market. You can see our list of FX trading platforms, FX market makers, as well as exclusive Volume Data.

If you are in need of a liquidity provider but aren’t certain on what you need, remember that users can use our Match Matrix tool, as well as our multi-provider request form to help you make a decision.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder.