What is Liquidity?
The Liquidity definition refers to the extent to which a particular asset can be bought or sold quickly on the market without having a significant effect on its price. Liquidity is an important factor that investors assess when making their trading decisions since it has an effect on their trades. It lets them know how quickly they can gain access to the market and how fast they can profit from trading a particular asset.
Liquid and Illiquid Assets
A liquid asset is one that can be bought or sold quickly at a minimal loss to its value at any time within market trading hours. The key characteristic that is used to identify a liquid asset is that it always has ready and willing buyers and sellers. This characteristic is similar to market depth but distinctive to it in the sense that depth is related to the trade-off between the quantity of an asset being sold and its price, while liquidity is a trade-off between how fast an asset can be sold versus its price. On the other hand, an asset that is not easy to sell without a drastic reduction in its price is said to be illiquid. This is often a result of uncertainty among traders with regard to its actual value, or it could be down to a lack of market interest for it to be regularly traded. In the global financial market, currencies are generally considered to be the most liquid assets, with collectables, real estate and fine art all being relatively illiquid.
Majors, Minors and Exotics
Liquidity plays an important part in categorising the currencies involved in the global forex trading that is based on the relative values of a pair of currencies. Based on their liquidity, there are three major currency pair categories: majors, minors and exotic currencies.
- Major Currencies:
These currency pairs are the most popularly traded globally. Due to their massive liquidity, they can be traded at almost any time at the lowest spreads. The major currencies include the U.S. dollar, the British pound, the euro, the Japanese yen, the Australian dollar, the Canadian dollar and the Swiss franc.
- Minor Currencies:
If a currency pair does not involve the U.S. dollar, it is considered a minor currency pair, also known as a cross-currency pairing.
Exotic currency pairs are thinly traded currencies, lack market depth, are illiquid and traded at low volumes. Examples of exotic currencies include the South African Rand and the Thai Baht.
How Liquidity Affects Forex Trading Strategy
The majority of currency traders tend to stick to major and minor pairings as they are easier to trade and have lower spreads. Exotic pairs are more of a challenge since their lower liquidity attracts higher spreads. That being said, you can still make money trading exotic pairs if you are an experienced trader with a good strategy. Take the time to understand liquidity and how you can benefit from trading different assets.
Liquidity main FAQs
How does liquidity affect capital markets?
When an asset is said to be liquid it means that there is a great deal of buying and selling of the asset. This makes it easy to sell since there are plenty of buyers willing to pay the market price for the asset. When an asset is liquid it also means that selling, even large amounts, has little impact on the price of that asset. Liquidity is typically thought of as very good, since a lack of liquidity means a trader could get trapped in a position with no buyers as price falls sharply.
How is market liquidity measured?
The most basic measure of liquidity in any asset is the bid-ask spread. When the spread is small it indicates there is sufficient liquidity, however if the spread is wider the liquidity of the asset may not be sufficient, especially if an investor needs to unload a large amount of the asset. Market liquidity used to be measured by the trading volume of an asset, but that is now considered to be a flawed indicator since high trading volume does not necessarily imply high liquidity. The market global financial crisis of 2008 and the flash crash of May 2010 are the clearest examples of this.
What is liquidity risk?
There are basically two types of liquidity risk. The first is cash flow risk in which a corporation is concerned with whether or not it can fund its liabilities. The easy way to avoid cash flow risk is through a line of credit or similar funding method. The second is market liquidity risk. This is the type of liquidity risk that a trader is concerned with since it is the inability to easily exit a position. One of the markets where this type of risk is most easily seen is in the real estate market. When bad real estate market conditions prevail, it may be impossible to sell a property at anywhere near a fair market price. Even though the property may have obvious value it can be impossible to extract that value in the absence of buyers.
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