Trading in Low Liquidity Conditions
During the couple of weeks around Christmas and New Year’s, depending on where they fall on the calendar, major equities traders and market makers typically go on vacation. The markets are still open, but there’s almost an unofficial agreement between the big players to just be away from their desks.
Unless there is a major issue in the markets at the time, traders can be expected to notice that market liquidity tends to try up, and this changes the dynamics in Forex, commodities and the stock market. This also called a thin market.
Governments tend to accommodate this period of vacation, adjusting the release of regular data (the RBA doesn’t have its usual start-of-the-month meeting in January, for example) around the holidays, and most corporations decline to release major reports during the period.
However, because of the holidays and the fact that people are mostly distracted, it is an opportunity for some less scrupulous firms to slip out some less than positive reports in the hopes they won’t move the markets.
What About Forex?
Forex is often billed as the most liquid market, with daily volumes reaching hear $5 trillion. But that applies to outside the holidays, with most banks (central and otherwise) already taking their stances before the holidays, and just maintaining their positions until the first few days of the year.
There isn’t a clear estimate of how much liquidity drops during the holidays, but it’s not rare to see certain currency pairs stay flat for several minutes. Even the most liquid pair, EURUSD shows clear signs of a lack of liquidity. So, what are those signs?
Generally, a lack of liquidity leads to higher volatility, but it’s harder to get trades to close within the expected range. This is because when you want to open or close a trade, there simply isn’t anyone interested in being a counterpart.
The bigger the size of the trade, the harder it is to find a counterpart for it. In the holidays, the market is composed mostly of individual traders exchanging a few lots at a time; and you might simply have to wait until someone is online if you are trading an exotic pair that has few traders.
Generally, in the more popular pairs, such as the EURUSD, GBPUSD, and USDJPY, this lack of liquidity manifests itself as a drop in volatility. In normal market conditions, volatility in those pairs is driven by market makers putting large amounts on the market.
Without large trades going on the market during the holidays, there are still enough “small” traders to take up trades, but rarely does anyone put on enough to move the market significantly. Trading is thus a lot similar to the Asian session.
However, in the majors, even though there is less volatility, trading can be somewhat erratic. That is to say, generally, market makers respond to technical and fundamental aspects to the market. But without market news, then trading can become more personal or even emotional, and not follow the same patterns.
This leads to even more traders wanting to stay away from the markets, further reducing liquidity, because the abnormal behavior makes their strategies less effective.
In the more exotic pairs, volatility might actually be exaggerated. This is because traders can’t find a counterpart to the trade, and have to offer a larger deviation from the market to get someone interested or trigger someone else’s order. This leads to gaps between the candlesticks even in the middle of the trading session. The erratic nature of the markets is therefore exaggerated by the increased volatility.
In general, however, the markets tend to move by inertia, either continuing the trend of the month or getting locked in a channel. Because there are few underlying fundamental changes during the period, there is nothing to really drive the markets.