Forex liquidity and volatility could affect each other in many ways. High liquidity often results in low volatility as the price fluctuation is low and the inverse is also true.
Given that the foreign exchange market is among the most liquid markets globally, the high liquidity prevents it from being extremely volatile. But this does not imply that we can rule out volatility entirely. The forex market also experiences fluctuating volatility time and again as currency pair prices keep changing frequently. Here’s a closer look at what Forex market liquidity and FX market volatility are and what role they play in the forex market.
What is liquidity in Forex?
In the world of forex, liquidity refers to the currency pair’s capacity to be bought and sold in the forex market without significantly affecting the exchange rate. Every time a currency is bought and sold with ease and without any solid changes in the exchange rate, it is said that it is a liquid currency.
When to be able to comprehend Forex liquidity, take into consideration the two things:
- The major currency pairs are the most liquid
- The exotic currency pairs are the least liquid
What causes liquidity in Forex?
1. Expansion in a monetary policy
If there is a change in the global monetary policy, it would have a certain impact on the foreign exchange rate as well as the liquidity. If a nation chooses to further expand its monetary policy in order to boost the cash flow, the incomes and demands of the citizens also rise. This leads to the exchange rate being lower owing to the local currency’s depreciation.
2. Increase in global credit supply
When the international credit supply rises, it indicates that a higher amount of loans and borrowings are being given to the people, which has a positive impact on liquidity. A higher credit supply is an indicator that traders and investors have more funds to invest in the Forex market which they use to purchase currency pairs, thereby boosting its liquidity.
3. Decrease in global credit demand
When the global credit demand falls, it shows that traders have sufficient funds to invest and trade. Thus there is no need for additional credit to be able to invest in the foreign exchange market.
A decrease in credit demand at an international level translates into better liquidity in the Forex market. But in case the credit demand increases globally, people may not have sufficient money to invest, which could result in low liquidity in the forex market.
What is volatility in Forex?
Forex volatility calculates how frequently a change occurs in the currency’s prices. If the currency is very volatile, the risk associated with trading it in the forex market would also be high. The following need to be taken into account when dealing with volatility in the forex market:
- The major currency pairs are the least volatile
- The exotic currency pairs are the most volatile
What causes volatility in Forex?
1. Interest rate changes
Changes in the rate of interest rate can also impact the Forex market’s volatility. If the interest rate of an economy rises, it indicates that the investors would control their spending. As a result, the domestic currency price may drop considerably leading to a highly volatile forex market.
In the same way, if the interest rate falls, the spending capacity will increase which would cause the domestic currency price to gain value in the market, once again leading to high volatility thanks to price fluctuation.
2. Economic shocks affecting supply and demand
Domestic shockers such as a change in the taxation policy or an unexpected spike in the prices of oil could have a negative impact on forex volatility. For instance, let us assume that a nation undergoes severe tariff impositions on trade which could have a negative impact on the majority of the people. In this case, the country would strive to bring down the participation of the population in the Forex market, which leads to a fall in the currency pair prices consequently causing volatility.
In a similar way, in case high demand results in an increase in oil prices in a specific nation, it may also result in an appreciation in the prices of the gulf countries’ currencies, since increased supply would mean better incomes. This will ultimately contribute to increasing forex volatility in terms of international currencies.
3. Global changes and events
A number of international changes and events such as a political election, natural disasters, wars, and many such occurrences could also wreak havoc on the market’s volatility. The most common instance is that when a nation is about to go to the polls, traders would typically not choose to invest in it. This is because a change in government could mean a change in the market sentiment which could lead to volatility.
How are liquidity and volatility related?
Forex market liquidity as well as volatility are linked closely. The foreign exchange market’s liquidity affects market prices too which causes a volatile or non-volatile market. If there is a low in the forex market, the market sentiment is volatile and leads to price fluctuations.
But in the times when the forex market is highly liquid, the market turns rather stable and the risks also reduce significantly.
Market liquidity is an indicator of the depth of buy and sell orders. You should be able to purchase and sell with ease in a liquid market.
Volatility is a sign of a market’s change rate. In a volatile market, the prices change quickly within a small time period. The level of liquidity can affect the technical analysis. Higher liquidity in the market ensures that technical patterns and breakouts can be expected to be reliable.
A ‘thin’ or illiquid market could turn volatile as there are lesser orders to cushion from the market fluctuations and it is simpler for the buyers and sellers to play with the prices.
You must develop a thorough understanding of the forex trading market if you want to invest in volatile currencies and earn profits. But if you are just starting out, we suggest you invest in a rather liquid currency that has the potential for good profits and is not very risky.