What is Liquidity?

What is Liquidity?

The Liquidity definition refers to the extent to which a particular asset can be bought or sold quickly on the market without having a significant effect on its price.

Liquidity is an important factor that investors assess when making their trading decisions since it has an effect on their trades.

It lets them know how quickly they can gain access to the market and how fast they can profit from trading a particular asset.

Liquid and Illiquid Assets

A liquid asset is one that can be bought or sold quickly at a minimal loss to its value at any time within market trading hours.

The key characteristic that is used to identify a liquid asset is that it always has ready and willing buyers and sellers.

This characteristic is similar to market depth but distinctive to it in the sense that depth is related to the trade-off between the quantity of an asset being sold and its price, while liquidity is a trade-off between how fast an asset can be sold versus its price.

On the other hand, an asset that is not easy to sell without a drastic reduction in its price is said to be illiquid. This is often a result of uncertainty among traders with regard to its actual value, or it could be down to a lack of market interest for it to be regularly traded.

In the global financial market, currencies are generally considered to be the most liquid assets, with collectables, real estate and fine art all being relatively illiquid.

Majors, Minors and Exotics

Liquidity plays an important part in categorising the currencies involved in the global forex online trading that is based on the relative values of a pair of currencies. Based on their liquidity, there are three major currency pair categories: majors, minors and exotic currencies.

Major Currencies: These currency pairs are the most popularly traded globally. Due to their massive liquidity, they can be traded at almost any time at the lowest spreads. The major currencies include the U.S. dollar, the British pound, the euro, the Japanese yen, the Australian dollar, the Canadian dollar and the Swiss franc.

Minor Currencies: If a currency pair does not involve the U.S. dollar, it is considered a minor currency pair, also known as a cross-currency pairing.

Exotics: Exotic currency pairs are thinly traded currencies, lack market depth, are illiquid and traded at low volumes. Examples of exotic currencies include the South African Rand and the Thai Baht.

How Liquidity Affects Forex Trading Strategy

The majority of currency traders tend to stick to major and minor pairings as they are easier to trade and have lower spreads.

Exotic pairs are more of a challenge since their lower liquidity attracts higher spreads. That being said, you can still make money trading exotic pairs if you are an experienced trader with a good strategy. Take the time to understand liquidity and how you can benefit from trading different assets.