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How Are Market Liquidity and Volatility Related?

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Man looking at candlestick chart

Happy Friday!

This week’s question comes from Abayomi, who asks:

What is the meaning of market liquidity and volatility? Are they related?

To the novice trader, terms like liquidity and volatility can be intimidating.

Not only do you need to fully comprehend terms like these, you also need to know how to apply them to your chosen profession.

If you’ve been trading for a while now, you probably know these terms like the back of your hand.

But even if that’s true, I bet there are a few things you haven’t thought about.

For instance, are the two related? If so, how?

Moreover, does liquidity affect technical analysis? How about volatility?

By the time you finish reading this lesson, you will know what liquidity and volatility are and how one affects the other. You will also understand the role both play when analyzing a market.

I will even share why I transitioned from equities to Forex in 2007. Hint: it’s a theory that applies to every financial market in the world.

Read on to learn how to make liquidity and volatility concerns an active part of your trading regimen.

Understanding Liquidity

Image of 100 dollar bill showing liquidityThe term liquidity refers to how quickly or easily something can be bought or sold in the market. It’s a way of measuring the depth of the market.

For instance, let’s say you want to buy the EURUSD at 1.20. As you may know, that involves buying the Euro and selling the U.S. dollar simultaneously. Of course, we never really see that because the order goes through as a single unit.

So how quickly can your broker execute that order?

If you’ve traded Forex for any length of time, you know that it’s almost instantaneous, despite your broker needing to find someone selling the Euro.

Remember, all trading is a zero-sum game. The Euro must be sold at 1.20 in order for you to buy it.

Luckily for you, the currency market is the most liquid financial market in the world. That means you can buy and sell without worrying about liquidity, especially with a pair like the EURUSD.

Respecting Volatility

Financial market showing volatility conceptYou might wonder, how rapidly is the EURUSD price changing?

This question, and its answer, describe the pair’s level of volatility. It’s the pace at which a market’s price changes over a specified period of time.

While there are volatility indicators out there, I tend to measure volatility visually. I like to keep a nice clean chart for trading price action, and I don’t need an indicator to tell me what’s already on the chart.

You’ll notice that volatility increases before, during and after news events. This is particularly true with an announcement such as non-farm payroll or a central bank rate decision.

During these times, it’s best to stay out of the market. At least that’s how I approach high levels of volatility.

Liquidity can also affect a market’s level of volatility.

During the holiday season between late November and early January, market volume dries up. This is also called an illiquid or ‘thin’ market.

The lack of buy and sell orders causes the market to fluctuate much more rapidly than usual. Without those extra orders, there’s less to absorb market fluctuations.

In other words, it takes less volume to move the market up or down. This, in turn, can equal greater volatility.

The Relationship Between Liquidity, Volatility, and Technical Analysis

There are no guarantees in trading. Well, almost no guarantees.

Having traded equities and Forex since 2002, I can vouch for the fact that liquidity affects technical analysis.

The more liquid a market is, the more reliable the technicals are likely to be.

I started trading equities in 2002. After five years, I decided to make the switch to Forex.

Why the change?

Two reasons come to mind.

  1. I enjoy being able to buy and sell a market without needing permission to do so.
  2. There’s far more volume in currencies than in any stock market.

The second reason is one that many traders don’t think about, or at least not in terms of reliability.

Now, I’m not saying that Forex is better than equities. It’s important to pursue the market that suits your needs and of course, piques your interest.

That said, when it comes to liquidity and the reliability of technical patterns, nothing beats Forex, in my opinion.

Think of it this way…

Every order in a financial market is an opinion. It’s an individual or institution’s way of casting a vote about whether they believe a market is going higher or lower.

The more votes there are, the more reliable and trustworthy the result.

Now, translate that logic to a break of channel resistance or the neckline of a head and shoulders pattern.

With all of this in mind, it should be quite clear why I tend to avoid trading during the holiday season. The decrease in liquidity around the month of December means that technical patterns become less effective. Markets also become prone to false breakouts.

The same can apply to Fridays when volume is lighter. If a market does break a key level just before the weekend, you may want to think twice before trading it on Monday.

Can volatility also affect the reliability of your analysis?

It sure can. So much so that I wrote an entire lesson on the subject.

You want to be careful when using a candle’s high or low that was the result of an extremely volatile session. Chances are the price will vary between brokers, making it an undesirable candle to use as part of your analysis.

Final Words

Market liquidity refers to the depth of buy and sell orders. A liquid market is one where you can buy or sell quickly.

Volatility refers to a market’s rate of change. A volatile market is one in which price changes rapidly over a short period of time.

The level of liquidity tends to affect technical analysis. The more liquid the market is, the more reliable technical patterns and breakouts are likely to be.

A ‘thin’ or illiquid market can also become volatile. With less orders to absorb market fluctuations, buyers and sellers find it easier to push price up and down. This is why I tend to avoid trading during the month of December.

Take extra precautions when using a high or low of a candle that formed during heightened volatility. The price may vary between brokers, making it difficult to ascertain the ‘true’ price in the market.

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Your Turn: Ask Justin Anything

I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.

To do that, I need your help.

Here’s what you can do to get involved and have your question answered in next week’s post:

  1. Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
  2. Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.

Leave a Comment:

54 comments
abdil fitah says

daily price is the best and the first fantastic of market
realy i like daily price action.

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    Justin Bennett says

    Thanks for the kind words. Much appreciated!

    Reply
Qpid wooden says

Daily price so far even tho I have not started trading yet, but I can say they take time to explain the prons and cons in fx trading they simply best I now know wat is Liquidity and Volatility of fx Market . thanks!!!

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Rin Savann says

Thanks you

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Les says

Thank you Justin for distnguishing volatility and liquidity.
What came to mind whilst I was reading the article was that besides fundamental analysis or announcemts do banks also cause volatily or liquidity when trading?

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Yazib says

Tqvm, I am not understand about volatility and liquidity before your explanation. Can you please explain why price do retracement after breakout

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    hereje says

    Becauze it wants to take your money 🙂

    Reply
    Segun says

    I like to get answer on this question as well.

    Reply
    george_trader says

    Let us take the example of a big move to the upside… For that move to take place, more buyers than sellers stepped into the market and pushed the price up.

    After this happens, many of them will want to get out of the market and book some or all of their profits. To do this, they need to sell, sell and sell; which will push prices down and create the retracement.

    Assuming the uptrend is real, the retracement should not break below the initial starting price. In other words, the retracement should be less than 100%. Typical retracements are the 38%, 50%, 61%, 76% and my own personal favorite, the 95%; which creates a ridiculously risk reward trade… but this topic is for another day.

    Finally, there is also another way to explain and see the retracements. Markets do a sprint (a swing), which is followed by a “resting period” = retracement… This should be seen as the market cooling down, resting for a bit, stretching its legs, simply getting ready for the next sprint. When the retracement is over, the market proceeds to do yet another sprint (swing).

    God bless your trading my friend. Wish you all the success you can handle.

    Thank you daily price action.com!

    Reply
Ibinabo says

Thanks a lot

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Vernon says

Hi Justin,thanks for this valuable info ,I also found your pinbar course very interesting.Keep up the great work .

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CYJ says

Would appreciate if you can share more about money management and leverage guidance and advices for trading account balance less than USD1k.

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bongani says

which strategy can one trade if working from 7am -16:00pm being a day trader checking on lunch and tea time

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Emmanuel says

For me the daily price action is my option anyday any time

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Harbex says

Hmm! Another great thought from Mr. Justin. Thanks for the tips.

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Ntando says

Hi Justin ,as a novice trader .I can’t say much about the fx teminology as yet ,cause every day am learning anew thing.

THANK YOU FOR THE INSIGHT…..

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Muhammad Naseem says

Great…… very good artical to understand both terms….

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Thomas says

I like your explanation.My problem is finding precise entry levels due to that I normally get stopped out though I get the market direction correct and how to combine fundamentals with technicals.Thanks for your help

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    Bokhory Raja says

    If your mkt direction is right just keep looking for the first point where the mkt begin to drop or rise, you will find your entry levels. Fundamentals is nothing only technicals rule the mkt and what Justin told about to stay out before and during the news, he is right. Keep looking at the charts and you will find it clearer day and day after. Hope that can help.

    Reply
Eengaku says

Mr Justin you are God sent, well explained notes for free where have you seen this ? I did not start trading yet, but with your help I will get there slowly but surely👏👏. Surely will be a guru in Forex true, growing bigger and better is 2018 resolution

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taiwo says

very educative

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salako gbola says

Thanks, very impressive more grease to your elbow.

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Fidi Kiko says

thank you for your simple and understandable explanation about volatility and liquidity.unfortunately by anouncements there is manipulation,news most times are overated or undervalued and using indicators is useless.only a naked chart of daily price action can avoid losses.

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    Bokhory Raja says

    There is no manipulation in the news but it will do what the mkt has long been doing, you just have to find out what its continuously doing and indicators will help, if it doesn’t help change to another one. They are not useless you need to find the right combination of indicators so that you can clearly see what the mkt is doing. News can have less impact when suppose full CPI for a country is 3.0 but will have no big effect if it rise to 3.1. Similarly int rates may rise by news but a dovish rise means it will fall that’s what we need to focus but indicators may tell you before news what the mkt will be doing. Hope that may help

    Reply
    Waziri says

    Fx encompasses varieties & style hence as regards your comments INDICATORS been useless are quite obsolete, indicators are useful depending on the traders knowledge & foresight’s. Fx all boils down to what works best for you.

    Reply
Grayson says

Totally agreed what you said “Every order in a financial market is an opinion. It’s an individual or institution’s way of casting a vote about whether they believe a market is going higher or lower.”

More voter more realible of the result. But now the question come in, in forex market all voter is not voted in the same centre or we can call it Exchange. In forex market, all price feeded by liquidity providers that cause every broker have different pricing.
Thus, One question come to my mind, how to choose a reliable and liquility broker become more important condition in forex market.
Thanks

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Kyi says

Thanks sir

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michael walker says

What about momentum in terms of liquidity and volatility

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Francis says

Dear Justin, what exactly is the daily time frame. Thanks. Hope to hear from you soon.

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michael walker says

Do you use divergence strategy.I might be wrong but to me it is an indication of exhaustion such as hammer,shooting star, pin bar etc

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michael says

What is volume in terms of liquidity,momentum and volatility.Sorry about multiple questions

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syaheed2008 says

you are good coach, in daily price action , now I used it , and took a lot of profit in trades, I combined it with ichimoku indicator . but I still learn n learn , thanks for u help and free course.

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Charles says

Is the Cryptocurency trading a”zero sum” business? If not, where does its power come from? With fiat currency the base is mainly gold, what about the bitcoin for example? They talk about “mining”, mining what with the computers?
I am not an economist, I am an electrical engineer, please excuse my naivety or stupid question.

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    Rostam says

    Hi Charles,
    I think that all “fiat currencies” are floating and their base is not “Gold”.
    This changed over 30 years ago!

    Reply
Lenny says

Thank you

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Babangida says

What does the phrase, “To smooth price action” means, when defining a ‘Moving Average’.

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Henok says

Wow thank you for your time.

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S.P. du Plessis says

My question: What determines my actual risk? The lot size I buy/sell or where I place my stop loss?

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shaiful islam says

Daily market tips and entry level confram need

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Milan Burget says

Hello Justin, thank you for the information.

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Mintu Kumar Biswas says

I need a Clear Article about Smart money trading,It is possible sir?

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Snikiwe Mgwaba says

I am learning a lot from you Justin, real appreciate that you are willing to share and educate us.

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Tomislav says

Hey Justin,
Love your site. You provide people with alot of useful info.
I have a question and am hoping you can give me an answer.
So when tra

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    Tomislav says

    So when trading how can I enter the market to maximize profits.
    I find it difficult because when I have a great setup it usually happens that the market moves about 50 and more pips in the direction I wanted but what happens then is I cant enter anymore because the market could reverse.
    When should I enter then, should I put a sell/buy limit or just watch the chart?
    Thanks alot

    Reply
Haitham says

Haitham Asha

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manoj says

thanku so much sir …always eager to learn your article..thanku so much for this valueable information…

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Chelsea Kisukwa says

1.Is forex real or scam.
2.Do brokers have an up hand to manipulate the market.
3. Who earns the money when I make losses

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Haitham says

Haitham 0796550851

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Ghulam Abbas says

Sir I like your analysis and chart patterns

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Eduardo Alvarado says

Hi Justin, do you think that algorithmic trading really works? And if so, what is the best robot for autotrading?

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Bullish India says

I really thank you for sharing the blogs with us. I request you to keep blogging and sharing because it is really helpful.

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Talal says

Why euro is always in the base currency in forex??

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Multibaggers.co.in says

I’m thankful for finding your blog post. I’ve bookmarked this site and will return again soon. Please post some tips or advice to keep in mind while investing in multibagger stocks.

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