What is Liquidity?
Liquidity is a term used in online trading to describe how much an asset can be bought or sold, without there being an impact on its price.
How is Market Liquidity Defined?
The liquidity of a particular market, for example, the Foreign Exchange (Forex) market, refers to the extent to which assets, in this case, currency pairs, can be traded at stable prices. The Forex market is in fact considered to be the most liquid market in the world, as it experiences high volumes of trading on a daily basis, which thus provides the market with increased liquidity.
The level of liquidity in a market can be seen in the difference between the bid (buy) and ask (sell) prices of any given asset, which is referred to as the spread. When liquidity is high, an asset’s spread will be low, as the price a buyer is willing to pay for said asset and the price a seller is willing to accept for that asset will be relatively close to each other. In comparison, if a market is experiencing low liquidity, or illiquidity, this means that the difference between the bid and ask prices of an asset are higher.
How Does Liquidity Affect My Trading?
Investors should always pay close attention to the level of liquidity in their financial market of choice. It is always recommended that amateur investors focus on the most liquid assets, which in Forex would be the major currency pairs (top traded pairs, featuring the U.S. dollar and another major currency). The reason for this is that, the most liquid assets in any given market experience the highest trading volumes. This, in turn, means that the transaction costs, such as spreads, associated with trading said assets will be much lower.
Market liquidity also affects an investor’s ability to open and close a position, as any buy or sell order must be respectively matched in price by another sell or buy order on the market. So, if liquidity in the market is low, trading volumes will also be down, meaning it will be more difficult for an investor’s order to be matched.
Low liquidity also makes certain assets prone to increased volatility, meaning their price is likely to move erratically at any given moment. In the Forex market, this can be seen with exotic currency pairs, which suffer from low trading volumes and are best avoided by investors with limited experience.