Why You Should Care About Volatility & Liquidity

Not all currency pairs are the same, evidently. And two of the ways they differ is in the level of volatility and liquidity.

Some pairs are more volatile and liquid, while others can be more liquid and less volatile, or vice versa. Given how often these traits are mentioned in literature, clearly, they are an important consideration when trading. So how do they affect your trading directly?

Volatility seems the most straightforward to explain. But both of these concepts are connected in a way that makes volatility a little more nuanced. Getting a good understanding of this relationship is not only useful when developing a trading strategy, but also helps refine your trading throughout the day, week and seasons.

Note that we’ll be talking about liquidity and volatility in the context of Forex. This is since commodities, bonds and indices have their own considerations.

Liquidity

Let’s start with the more complicated of the two elements.

Liquidity refers to how much money is in the market interested in trade right now. You might have heard that Forex is the most liquid market out there (since it’s composed of, well, money.) And this is true! But not all of that money is available for trading at the same time. A currency pair with high liquidity is one where there are lots of traders interested in trading large volumes.

Naturally, more popular currency pairs such as the EURUSD will have a lot more liquidity than exotic pairs that are niche or special, such as AUDNZD. But the liquidity of pairs also depends on what time of the day, or in what season we are in.

For example, if there is a holiday in Japan, then Japanese traders won’t be trading. So there will be less liquidity in the USDJPY. There is more liquidity when there are more traders, so while Europe and the US markets are open, there is more liquidity in all pairs than when just Australia is open.

How This Affects the Currency Pairs

CFD traders are insulated from a lot of the effects of liquidity, which is why it’s often ignored by retail traders. But there are two circumstances that can affect us as retail traders:

• If there are fewer traders, it’s less likely for them to form a block of “bulls” or “doves” to push the market in a particular direction. Lower liquidity usually means that the market will move slower. “Ticks” (a move in the market because a trade is entered) are less frequent.
• On the other hand, if someone comes to the market with a large trade, or there is an important event, there are fewer traders available to “smooth” the currency move, so you can get surprise jerking moves. Low liquidity markets could be described as more erratic.

What This Means for Volatility…

Volatility is the frequency with which the market goes up and down. Not just how many times it changes direction, but how far those changes go. A currency with more ups and downs is considered more volatile. And a currency with wider swings is also more volatile.

Because currency traders are interested in gaining pips by market moves, volatility is the lifeblood of the Forex trader. But volatility also implies more risk, so it’s about finding the right balance. Volatility can be increased with economic data, as well as more people coming to the market.

The Connection

More traders in the market with more cash is what we call increased liquidity. So, in general, you could say that less liquid circumstances would imply less volatility in general, all things being equal. But you can have higher volatility in response to news releases, or something changing the market fundamentals.

Now that you know how this works, you can keep track of volatility and liquidity to adjust your trading strategy to get the most out of the markets.