Since the beginning of time, liquidity has been a crucial aspect for all businesses. An organization can be really prosperous, however in the absence of adequate liquid assets it could come face to face with financial crises quite easily. When we often come across the term bankruptcy, the mention of lack of liquid assets is not too far away. Most of us have heard of well-reputed companies getting wiped out of the market due to their lack of the ability to pay off debt or creditors in the absence of liquid assets (just as the financial crises of 2008).
A global example of this is the European country Greece. Regardless of how beautiful it is, and how tourism continues to thrive there, the lack of liquidity has hit its economy. In fact, had it not been for the support of the European Union to provide it with additional liquidity, the country would have tanked in no time. Regardless of all the help already provided by the EU which keeps Greece afloat, there is still a chance for it to lag behind on the payment of its debt to the IMF, which will propel the country but only towards bankruptcy.
So hopefully by now, you have a little idea about the importance of liquidity. Based on the points put forth by Fuad Ahmed, we will be explaining in detail as to why liquidity is important in the forex market and to a forex trader.
What is liquidity?
Allow us to elucidate with an example: if during an important quiz, the whole class had only one book to prepare from, how long would it take for all the students to get ready for the test? The demand for that book would surpass the demand of any other commodity. In simpler terms, we are witnessing a book market with no books!
So, to be brief: Liquidity is the current demand for a commodity or a service. Think about how fast can you sell your computer? Or how quickly can you sell your designer bag and turn it into cash? So, when we are referring to liquidity in the financial market, we are talking about the ability of an asset to turn into cash quickly. Some assets are more often than not known for their liquidity. Take the example of US bonds. They can easily be sold and bought by anyone, regardless of their geographical location. However, in contrast, Greek bonds aren’t sold as easily as the US bonds because there is an everlasting fear of the country going bankrupt which is why people hesitate to invest. So, if we extend this example to forex, we’d have to say the same goes for currencies. While some tend to be easily bought and sold, there are others that have a difficult time being traded. For example, if you are going to a third-world country and you can’t find its currency in your own country, you’d exchange your own currency into USD. When you do get to the country you were travelling to, you can simply exchange the US dollars you have for the native currency. This goes to show how liquid and readily available the US dollar is, which is why it is one of the most liquid currencies in the world.
Signs of liquidity
Even though the stock exchanges can easily be termed as the most liquid market, it is not always the case. The reason is because during uncertain events or off hours, investors tend to close their positions, thus causing the market prices to move very rapidly.
Although at times you can notice gaps in the forex market as well, they are usually not as prevalent as in the stocks market. However, the most typical indicator of inspecting liquidity in the forex market is to keep an eye on the long candles that occur in a relatively short period of time.
One such event that we want to shed light on happened a few years ago when the 1.20 peg from EUR/CHF was eliminated, which led to the fall of the currency pair by 40 cents in the matter of a couple of seconds as investors withdrew their investment from EUR/CHF pair. This indicated that a liquidity hole led to major downfall in CHF pairs.
In the forex market all of the participants play a crucial role in determining the liquidity. However, individually there are some banks that are perhaps more important than the rest. These are commonly referred to as Tier 1 liquidity providers and comprise of banks such as Deutsche bank, HSBC, Barclays, etc.
Importance of liquidity for a forex trader
Forex market is perhaps the biggest example of a decentralized market that operates without having a physical location. Even though the Frankfurt exchange floor is a popular location where forex exchanges occur, it accounts for a negligible portion of the total trades made. So typically, the forex trades are made electronically. If we take into account the record onwards April 2013, it is estimated that everyday an approximate amount of $5.3 trillion is traded on a daily basis. This fact goes to show the liquidity that is associated with the forex market.
The importance of liquidity for a forex trader comes into play because due to this liquidity a trader can make use of the mechanical trading systems, which has led to the popularity of algorithmic trading.
Since a liquid market follows patterns and trends it is more logical and easier to comprehend. Also, because the liquidity holes in this type of market are scarce, the chances of you occurring a huge loss are significantly minimized. So, unlike in the stocks market, you can make use of different strategies to optimize your profits. Nowadays, there are also platforms readily available for this purpose, which allow you to carry out your trades with even more ease. This is perhaps one of the reasons why we see a huge volume of traders leaning towards the forex market.