Liquidity and Volatility

liquidity volatility

The foreign exchange market, also known as forex, is the largest financial market in the world, with an average of over $5 trillion worth of transactions taking place every day. That’s around 100 times more than the New York Stock Exchange (NYSE) – the world’s biggest stock exchange. The liquidity and volatility of the various forex markets are important things to consider if you want to make it big with forex trading. But what do these terms mean, and how do they affect trading on the forex market? Read on to find out more.

What is liquidity?

Put simply, the liquidity of a market is a measure of how active the market is. A liquid asset is one that can be more easily traded in a market, and is fewer degrees of separation away from cash. 

Forex, being a currency exchange market, has no degrees of separation from cash, which makes the forex market an incredibly liquid market at all times. Forex is readily traded on the market, and there are ample buyers and sellers, making the forex market a relatively stable one to invest in, though this can be a problem for people looking to earn profits in the short term.

What is volatility?

The volatility of a market is a measure of the amount it fluctuates in any given price cycle. Markets with low liquidity tend to have higher volatility, due to the absence of buyers, and greater degrees of separation from cash affecting rates of supply and demand. 

Because of this, forex markets tend to be less volatile due to the high liquidity of forex assets and the frequency of buyers and sellers. With a number of traders trading at the same time, prices tend to move in smaller increments.

However, this is not to say that forex markets are devoid of volatility, and precautions must be taken to mitigate the effects of volatility.

Impacts on the forex market

As mentioned previously, forex markets often enjoy high levels of liquidity alongside lower levels of volatility. This can be useful if you want to play the long game, but for short-term traders the high liquidity and low volatility means that opportunities for profits are fewer and further between.

To counteract the low levels of volatility in the forex market, some traders deploy high degrees of leverage when trading. This makes smaller movements in the market count for more, but with high rewards come high risk, and investing in this way can make the forex market a more tumultuous one than it would otherwise be.

How to handle volatility

Volatility in a market is a double-edged sword- while big fluctuations can also reap big rewards for an astute trader, they can also make for an unpredictable trading experience with the potential for significant losses if not handled correctly. 

The forex market is a very liquid one, but whether you decide to deploy high degrees of leverage or not the consequences of volatility needs to be something at the forefront of every trading decision you make. Here are some tips for handling, the volatility of trading markets to maximise profit and refine your trading style:

  • Diversify your portfolio

As with all types of trading, it’s important to expand your horizons when trading on the forex market. Investing too heavily in a single currency could leave you inflexible when the market changes, particularly if you are deploying higher degrees of leverage when trading. By diversifying your forex portfolio, you can respond to fluctuations in the market more effectively, and be in a better position to make informed decisions.

  • Prioritise money management

A lack of experience, skills and emotional control are some of the main reasons why traders lose money. This is where money management is important- to keep risks and losses at bay. Even in a highly liquid market like forex, trading can still be volatile and are prone to risk, and money management techniques are an effective way to mitigate the effects of that risk. These include setting up Stop Loss and Take Profit orders, as well as organising your trading processes with a dedicated spreadsheet.

  • Keep track of your trading impulses

It’s very easy to let your emotions get the better of you when trading, and trying to balance volatility and liquidity can be much harder if your judgement is clouded. Keeping your trading impulses organised and documented is an effective way of avoiding poor judgement, and there are many ways you can systematically evaluate your trading decisions.

Spreadsheets can be a useful tool for documenting your performance, and keeping a trading diary to jot down your thoughts about a particular trade when it happens can be an invaluable reference whether your trades turn out well or not.

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