Market liquidity. What does a trader need to know?

Market liquidity. What does a trader need to know?

Today let's talk about the term "Market Liquidity." There are many definitions of this term on the web, but they are often complicated or incomprehensible.

Let's say it simply: "Liquidity = Money." Market liquidity means that the more money there is at some price level, the more liquidity there is, and vice versa. Typically, liquidity is calculated based on the volume of pending trades currently on the market. These are all pending (limit and stop) orders that have not yet been executed or have not found the second participant of the transaction.

High liquidity is when at each price level, the volume of counter orders is so large that it is difficult for the price to move in any direction. Low liquidity is when there is little or no volume of counter orders at price levels. In this case, the price can move quickly and impulsively until it finds enough counter-liquidity to stop this movement.

Before moving on to the example, it is important to note that market (stop) orders are only executed against limit orders in the financial markets.

Now let's move on to the example.

Let's say a trader wants to buy ten lots on the EUR/USD currency pair for 1.0000. The trader clicks the buy button, and this order starts looking for counter orders (sell limit orders) that can meet this volume. The buyer must find a seller for the transaction to take place, as in real life. But let's say there are only five lots of sell limit orders at the price of 1.0000. At the price of 1.0001, there are only three lots and two more lots at the price of 1.0002. Eventually, the price of EUR/USD will jump from 1.0000 to 1.0002, worsening the average entry price for the buyer. And this is the reason why trades can "slide" in the market. Slippage occurs only with market orders when counter-limit orders cannot fully satisfy the volume of market orders. Thus the price moves to the next level and further until the market order is fully satisfied.

Why is it important for traders to understand market liquidity?

Market liquidity is important for a number of reasons, but primarily because it affects how quickly and accurately you can open and close positions. This is why it is important to trade instruments with sufficient liquidity and avoid instruments with low liquidity.

Before important news releases (FOMC Statement, Nonfarm Payrolls, Consumer Price Index, Interest Rate Decision, and so on), market-maker trading algorithms remove most of their limit orders, both buy and sell. This is the reason why a small amount of new market volume can cause a significant price shift at this time. This happens because there is not enough liquidity at the nearest price levels. In other words, low liquidity causes high volatility, and vice versa; high liquidity causes low volatility in the market.

Financial markets live and exist due to new liquidity. As a rule, new liquidity is behind price extremes (high/low of the trading session, day, week, or month). There is also a lot of liquidity behind equal tops or bottoms (double/triple bottom). And this is the main reason why the market will tend to these price points.

Have a good trade.

Start trading

by JustMarkets, 2022.09.29

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