How Are Market Liquidity and Volatility Related?

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.

The 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.

You 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.

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.

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.

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.