Up until now we’ve referenced the terms volatility and liquidity, and we’ve yet to fully explore definitions and meanings for these conditions as they relate to the forex marketplace. Generally, the more volatile a market, the better for short-term speculators looking to make a quick return. The less volatile a market, the better a long-term investment it may make, in the sense that it will prove less risky. If a market is more liquid than another, it enables transactions to be completed with greater ease and leads to more honest pricing. But what do these terms mean each individually, and what does this mean for you as a forex trader?
Volatility is a measure of how far a market moves in any given price cycle. In the same way volatility in human personality would indicate the potential to easily anger or swiftly sadden, so too in market terminology does it represent those markets that have a wider cycle between highs and lows. Volatile markets are opposed on the pole by stable markets, which tend by definition to have shorter cycles, with less of a gap between high and low market prices.
More volatile markets pose better opportunities for leveraged traders to make a profit in as short a period of time as possible. The bigger the swing in prices, and the greater the likelihood for markets to move, the greater the chances for the trader to wring out profit from their trade.
With forex, the currency markets tend to veer towards the less volatile end of the market, because those that drive the prices tend to be governments and massive global banks. For this reason, serious degrees of leverage tend to be involved in most forex transactions, as a compensatory measure to ensure traders can still maximise their returns.
In the same breath, liquidity is another key issue affecting traders across all different types of markets. Liquidity is measured as the proximity of an asset or market to cash. So for example, a car is an illiquid asset, because it is at least several degree of separation from cash (finding a buyer, concluding a sale and exchanging the asset for cash value all take time and pose additional risks to the asset holder). With forex, foreign currency literally is cash, and therefore its no surprise that the forex markets are the most liquid markets there are. Added to which, there are real incentives for international monetary supplies to be monitored in relation to geopolitical and economic goings on, and the impact of many disparate traders with disparate needs ensures that reasonable, realistic market prices can be achieved.
Liquidity and volatility are important terms to get your head around before you throw yourself any more directly into the forex markets, and they play a critical role in helping inform your trading decisions. But as a low volatility, high liquidity marketplace, what are the benefits of forex trading for regular retail traders like you?
High Liquidity / Low Volatility
As mentioned above, in many respects, low volatility is a disadvantage for short-term traders. The idea behind trading over shorter periods of time is that you quickly grab a profit from lesser market movements and move on. With a market lacking in volatility, these opportunities are fewer and further between, and as a result tend to be considered as more suitable bases for long-term investment.
Of course, in the same breath a market lacking in volatility is one that is unlikely to totally collapse, so the movements we are concerned with are on a much smaller scale and much less ferocious.
To counteract the effect of suppressed volatility in the forex markets, traders can deploy extensive amounts of leverage in each transaction. This has the effect of making smaller movements count for much more, because the whole transaction is magnified by the proportion of leverage involved. So, for practical purposes, volatility in the forex market is largely corrected by the role of leverage, and thus the advantages of a lower risk profile are offset by massive leverage amounts.
When it comes to liquidity, the forex markets are completely unparalleled. No other market in the world has such liquidity, which means no other market is as efficient as forex in terms of accurately reflecting market value. There are very few distortions, because there is little delay and ample demand when it comes to trading positions. With many governments, central banks and massive private institutions investing in currency, the market is never short of buyers and sellers, which in turn makes prices as accurate as possible.
This has many plus points for traders. Not only does the liquidity ensure that market prices are as fair and accurate as possible, but it also means that traders can close and open positions virtually instantly. Unlike other markets where there may be a time delay between instruction and execution, the forex market has so many different participants and so much trading volume that transactions can be completed in a fraction of the time.
The liquidity in the forex markets arises because currencies are the definition of liquid assets, and because there are so many alternative players involved that have the capacity for fill supply and provide demand across the markets and across alternative currency pairings. Furthermore, with leverage amounts available on margins as low as 0.2%, the liquidity and volume traded in the market is massive and flows constantly.
It is this liquidity that makes the forex markets are popular place for traders of all kinds. In terms of leverage and liquidity, there are no rivals, and for traders engaged in financial speculation, the ability to trade purely liquid assets with the potential for high returns and rewards makes it more than an attractive proposition. This, in turn with massive investment support from large banks, funds and state organisations, makes it the perfect market to trade within.