What Liquidity Is and Why It Matters

Your 200-year old professor probably told you that liquidity is the degree to which an asset can be bought or sold in the market without affecting its price. While there’s nothing wrong with your professor’s adage, I like to think of liquidity as an asset’s popularity.

A “popular” asset would have hordes of groupies and haters, or in geek speak -buyers and sellers. As an example, consider my twin, Brad Pitt. As a popular A-list celebrity, he would probably pay less attention to one hateful tweet than a washed up D-lister like Pauly Shore would.

Also, the positive comments from his numerous fans will cancel out any negative comments from the haters. Besides, Brad would probably be too busy minding his beautiful family, fame and fortune to notice such an insignificant event.

In the same way, a single buy or sell order would have less impact on the price of a highly liquid currency pair as more buyers and sellers cancel each others’ positions over the pair.

During the holidays (Thanksgiving, New Year, BabyPips.com day, and the like), liquidity in the forex market usually dies down because the big boys of trading usually go on vacation. This can be very problematic for small traders as it leaves price action purely in the hands of bigger traders.

As I’ve said in the beginning, the more liquid a financial instrument is, the smaller the effect large trading volumes have on price. The opposite also holds true: the less liquid a financial instrument is, the larger the impact huge trading volumes have on price.

Look at what happened to EUR/USD and GBP/USD Monday. While you could say that it was Moody’s credit downgrade warning that caused the pairs to drop, you can’t deny that it was mostly the low level of liquidity that allowed the bulls to push the pair so strongly in one direction.

Now, what good would all this knowledge be if we couldn’t apply it to our trading? Let me give y’all a few tips on how to make the most of the holiday season’s low liquidity. Who knows, you might just earn yourself a few extra bucks for some last minute shopping!

  1. Stick to the pairs that are most frequently traded, such as EUR/USD, USD/JPY, and GBP/USD. Not only are they the most liquid pairs around, but they also tend to exhibit recognizable price patterns that you may be able to capitalize on.
  2. Consider trading other time frames. If you want action, lower time frames are where it’s at! The hourly and 15-minute time frames can present plenty of opportunities for those who can act fast. But if you’re looking for a smooth, slow ride, then maybe you ought to consider the daily and weekly charts.
  3. Know which trading sessions to trade. Market players are aplenty and the markets are most liquid when the London session and New York session overlap from 1:00 pm GMT to 5:00 pm GMT.
  4. Be on the lookout for breakout plays. Times of low liquidity can be marked by dull price action followed by sudden, explosive movements. Stay alert and be ready to trade any breakouts that may emerge!
  5. …or don’t trade at all. If you’re really not comfortable trading under these conditions, then hang up your trading gloves early and get a head start on the holiday celebrations! ‘Tis the season to be jolly, after all!

There you have it, folks! With these tips, maybe you’ll find yourselves ho-ho-ho-ing your way into 2011!