In fx trading, liquidity is your friend. The more, the better. It keeps the spread between the bid (buy) and ask (sell) price tight because there is more competition for filling the next transaction. Tighter spreads give you a better chance to earn a higher profit (instead of paying out more money to execute your trades). Reduced fx liquidity happens under 2 circumstances. A horrible surprise might hit fx markets (e. g., a political assassination) or trading is now taking place during a time period when people traditionally eat dinner (e. g., late in the Asian trading session). As a fx trader, you have to decide if you really want to trade through either of these 2 circumstances. In both cases, your potential profit is going to be reduced (because you had to pay more to execute your trades).
The most liquid time of the fx trading day is when both Europe and North America are open for business. The next most liquid time is when North America is doing its thing.
FX Market Liquidity Under The Spotlight
In fx trading, “liquidity” means all cash that is available for trading. A “highly liquid” market is one that has lots of cash sloshing around in it. This keeps bid and ask prices close to each other, resulting in a “reduced spread”. That’s good. When a market is “illiquid” or “thin”, then the amount of cash available for trading has shrunk or disappeared for some reason. When this happens, the spread between the bid and ask price widens and may get to the point that you don’t want to pay the price of putting on a trade in such a market. An example of a “thin market” is after North American trading closes and before trading in Sydney starts up.
Why Liquidity Helps Your FX Trading Results
Short-term fx traders (particularly day traders) can really be affected by the price they pay to get in and out of a trade. They need abundant liquidity to keep the bid/ask price spread as narrow as possible. For example, if the usual cost of entering a EUR/USD trade is 2 pips, but all of a sudden it jumps to 4 pips, then what has really occurred is that, if you go through with this trade, your potential profit just got fleeced for those “2 extra pips”. If this also happens when you get out of your trade, then you got ripped for “4 extra pips”. Now, your “gross trade execution cost” is a total of 8 pips – representing a 50% increase.
Choose More Liquid FX Trading Markets
Certain regional fx markets, at certain times of the day, are traditionally more liquid than others. For instance, Asian trading mornings are usually much more liquid than Asian trading afternoons. However, in Europe, it’s the opposite (since North America wakes up in “Europe’s afternoon” and joins in trading what is now a cross-Atlantic liquidity pool). Generally speaking, when Europe is open, liquidity in all EUR-related pairs is higher than any other time of the fx trading day. The same is true for USD- and CAD-related pairs when New York and Toronto are open. Some currency pairs also have natural homes that produce a deep pool of liquidity when their home trading hub is open (e. g., Sydney and all AUD-related pairs).