Liquidity

Liquidity refers to the extent of a financial instrument’s ability to be bought or sold without causing price fluctuations.

Thus, if an asset is extremely liquid, it means one can trade that asset in the knowledge that one’s specific dealing won’t create significant movements in the market.

This is because there exists such a large number of traders going both long and short, generating huge volume for that particular asset.

Liquidity in the FX Market

Take the example of the foreign exchange market – it is the world’s most liquid market, since numerous banks, hedge funds and individual traders partake in the buying and selling of vast cumulative amounts currencies every single day.

In fact, over $5 trillion is exchanged daily, as mentioned by the Bank of International Settlements.

If a trader wants to go long on the currency pair EUR/USD, they will have no trouble in finding traders wanting to go the opposite way, due to such ample liquidity.

The EUR/USD is the world’s most liquid trading instrument, in any market. It is extremely easily bought or sold, with an immense quantity of trading activity for the pair.

Liquidity reflects the quantity and the frequency of the asset that’s being traded, i.e. the more an asset is traded, the more liquid that asset is, making it virtually effortless for the asset to be bought and sold.

Likewise, the less an asset is traded, generally the less liquid the asset is, making it more difficult for that asset to be bought or sold.

It goes without saying that liquidity is one of the key attributes a trader looks for, when deciding on whether to pursue trading an instrument, since it tells the trader how stable a market is despite masses of trades being undertaken.

This is exactly why the forex market is so enticing, since its liquid environment allows massive trading volumes to occur without much effect on the currency pairs’ exchange rates.