What is Liquidity?
Throughout your trading journey, you’ve probably come across the words ‘liquidity’ and ‘volatility’. It’s time to break down these key terms so that you can effectively incorporate their presence into your trading strategy.
First up, liquidity.
Liquidity refers to how easily an asset can be quickly bought or sold. Cash is considered to be the most liquid asset, whilst property is ‘illiquid’ because of how long it takes to convert into cash.
Why is Liquidity important in the markets?
A heavily traded product happens when there is a lot of orders placed to buy under the current price, and sell, above the current price. Traders add to the volume, so the spread (the difference between the Bid and the Offer) gets tighter. This means the trading cost is lower for you – always a good thing!
Here are some of the biggest traders of the most liquid market and their volume of trades per day:
- Foreign exchange - $5 trillion
- Banks - 24%
- Hedge Funds - 11%
- Corporations - 9%
Low Liquidity and Illiquidity
When high volatility happens, liquidity may be reduced as many large market participants, such as banks, pull their orders. The lower the liquidity, the wider the spread can become. At Trade Nation, our spreads are always fixed. That means, no matter what the market does, you’ll always find the same spread – even in period of illiquidity!
Illiquidity is when a product is difficult to sell, which can become dangerous as you may struggle to close a position. These drastic changes result in ‘gaps’, where the market passes through without price levels trading.
Largely watched economic results, such as the Non-Farm Payroll release (US employment), can result in market ‘gaps’ if the actual figure is very different from what’s expected.
Here’s an example of the steps in NFP:
- USDJPY trading at 111.05-111.03.
- The NFP result highlights that the employment rate and individuals claiming benefits has dramatically risen above the consensus.
- Traders quickly withdraw their bids and the next level to sell USDJPY is 110.80.
- This has left a gap open from the 111.05 offered to 110.80 with an offer at 110.83.
- The gap is 111.05-110.80, where the market has failed to trade.
- It should be noted that gaps are like windows and will normally be closed.
Liquid and Illiquid markets
Trading liquid markets has the benefit of tighter spreads and the fact that the underlying product can be easily bought and sold. It may become harder to buy and sell during illiquid periods as there are fewer buyers and sellers.
It’s important to be aware of liquidity when you’re trading as it can impact your trading strategy significantly. Volatility is also a key trading term need to know.