This week’s question comes from SJBABY, 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 must you thoroughly comprehend phrases like these, but you must also be able to apply them to your chosen job.
If you’ve been trading for a while, you’re probably very familiar with these terms.
Even if that’s the case, I’m sure there are a few things you haven’t considered.
Are the two, for example, connected? If so, how would you go about doing it?
Is liquidity a factor in technical analysis? What about the possibility of volatility?
By the end of this lesson, you’ll understand what liquidity and volatility are, as well as how one influences the other. You’ll also comprehend the importance of both when studying a market.
I’ll even explain why I switched from stocks to Forex in 2007. It’s a hypothesis that applies to every financial market on the planet, as a hint.
Continue reading to understand how to include liquidity and volatility issues into your trading strategy.
Liquidity: An Overview
Liquidity refers to the ease with which anything can be bought or sold in the market. It’s a means of determining the market’s depth.
Let’s imagine you wish to buy the EURUSD at a price of 1.20. As you may be aware, this entails simultaneously purchasing the Euro and selling the US dollar. Of course, because the order is processed as a single unit, we never see this.
So, how quickly can your broker put that order into action?
If you’ve ever traded Forex, you’ll know that it’s practically instantaneous, despite your broker’s requirement to find someone willing to sell the Euro.
Keep in mind that all trading is a zero-sum game. In order for you to buy the Euro, it must be sold at 1.20.
Fortunately for you, the currency market is the world’s most liquid financial market. That implies, especially with a pair like the EURUSD, you can buy and sell without worrying about liquidity.
Volatility must be respected.
The financial market illustrates the concept of volatility.
You might be wondering how quickly the EURUSD exchange rate changes.
This question and its response describe the volatility of the pair. It’s the rate at which the price of a market fluctuates over a set length of time.
While there are volatility indicators available, I like to visualize volatility. I prefer to trade price action with a clean chart, and I don’t need an indicator to tell me what’s already on the chart.
You’ll notice a spike in volatility before, during, and after major news events. This is especially true when it comes to important announcements like non-farm payrolls or central bank rate decisions.
It’s best to avoid the market during these times. That’s how I approach high levels of volatility, at least.
The level of volatility in a market can also be influenced by liquidity.
Market volume dries up over the holiday season, which lasts from late November to early January. This is also known as a ‘thin’ or illiquid market.
The market fluctuates much more quickly than usual due to the lack of buy and sell orders. There is less capacity to absorb market volatility without those extra orders.
To put it another way, less volume is required to drive the market up or down. As a result, there may be more volatility.
Liquidity, Volatility, and Technical Analysis: What’s the Connection?
In trading, there are no guarantees. There are almost no assurances, to be sure.
I’ve been trading stocks and forex since 2002, and I can attest to the fact that liquidity has an impact on technical analysis.
The more liquid a market is, the more trustworthy the technical’s are.
In 2002, I began trading stocks. I made the decision to go to Forex after five years.
What is the reason for the change?
There are two explanations that come to mind.
- I like being able to buy and sell a market without having to ask permission.
- Currency markets have significantly higher volume than equity markets.
- The second argument, at least in terms of reliability, is one that many traders overlook.
Now, I’m not suggesting that Forex is a better investment than stocks. It’s critical to seek for a market that meets your requirements and, more importantly, piques your curiosity.
However, nothing tops Forex in terms of liquidity and the consistency of technical patterns, in my opinion.
Consider it this way…
In a financial market, every order is an opinion. It’s a means for a person or an institution to vote on whether they believe a market will rise or fall.
The higher the number of votes, the more reliable and trustworthy the outcome.
Now apply that idea to a channel resistance break or a head and shoulders pattern’s neckline.
Given all of this, it should come as no surprise that I avoid trading around the holidays. Because of the decline in liquidity in December, technical patterns become less effective. False breakouts are also becoming more common in markets.
On Fridays, when the volume is lower, the same can be said. If a market breaks a crucial level soon before the weekend, you might want to reconsider trading it the next day.
Is it possible that volatility will have an impact on the accuracy of your analysis?
Yes, it is possible. So much so that I dedicated an entire class to it.
When using a candle’s peak or low from a very volatile session, you should use caution. Because the price is likely to vary between brokers, it’s not a good candle to utilize in your study.
Final Thoughts
The depth of buy and sell orders is referred to as market liquidity. A liquid market is one in which you can swiftly buy or sell.
The rate of change in a market is referred to as volatility. A volatile market is one where the price fluctuates dramatically over a short period of time.
Technical analysis is influenced by the level of liquidity. Technical patterns and breakouts are more likely to be dependable when the market is more liquid.
A ‘thin’ or illiquid market can be volatile as well. Buyers and sellers find it simpler to push prices up and down when there are fewer orders to absorb market swings. This is why I try to stay away from trading in December.
When using a high or low of a candle that developed during a period of significant volatility, take extra precautions. The price may differ amongst brokers, making it impossible to determine the market’s ‘real’ pricing.
