Forex Investment and Currency Trading

On the most basic level, risk in currency trading is the same as trading in any other financial market – the risk is that you’ll lost money. But risk comes in many different forms and from many different sources. Sometimes the biggest risks are the ones that you never knew existed.

Market liquidity, volatility, and gap risk

The forex market is routinely described as the most liquid financial market in the world, and that’s true. But it doesn’t mean that currencies are not subject to varying liquidity conditions.

Liquidity refers to the amount of market interest (the number of active traders and the overall volume of trading) present in a particular market at any given time. From an individual trader’s perspective, liquidity is usually experienced in terms of the volatility of price movements. A highly liquid market will tend to see prices move very gradually and in smaller increments. A less liquid market will tend to see prices move more abruptly and in larger price increments.

Shifting liquidity conditions can increase volatility

Forex market liquidity will vary throughout each trading day as global financial centers open and close in their respective time zones. Reduced liquidity is first evident during the Asian trading session, which accounts for only about 17 percent of global daily trading volume. Japanese data or comments from officials may provoke a larger-than-expected or more-persistent reaction simply because there is less trading interest to counteract the directional move suggested by the news.

Peak liquidity conditions are in effect when European and London markets are open, overlapping with Asian sessions in their morning and North American markets in the European afternoon. Following the close of European trading, liquidity drops off sharply in what is commonly referred to as the New York afternoon market.

During these periods of reduced liquidity, currency rates are subject to more sudden and volatile price movements. The catalyst could be a news event or a rumor, and the reduced liquidity sees prices react more abruptly than would be the case during more liquid periods.

Another common source of erratic price moves during less liquid periods is basic short-term market positioning. A classic example is a strong rally in a currency pair during the North American morning / European afternoon. As Europe heads home, the currency pair typically settles into a consolidation range near the upper end of the day’s rally. If sufficient short positions have been established on the rally, further price gains may force some shorts to buy and cover. With reduced liquidity, prices may jump abruptly, provoking a flood of similar buying from other shorts, resulting in a short squeeze higher.

The same phenomenon can occur following market declines, where market longs are forced to exit in a rush on further price declines. Still another variation on this theme is sharp price reversals of an earlier rally, where longs take profit in thin conditions and the resulting price dip brings out selling by other longs rushing to preserve profits. After a sell-off, profit-taking on short positions can provoke a sharp short-covering reversal.

There’s no way to predict with any certainty how price movements will develop in such relatively illiquid periods, and that’s the ultimate point in terms of risk. The bottom line is that if you maintain a position in the market during periods of thin liquidity, you’re exposed to an increased risk of more volatile price action.

Liquidity is also reduced by market holidays in various countries and seasonal periods of reduced market interest, such as the late summer and around the Easter and Christmas holidays.

Typically, holiday sessions result in reduced volatility as markets succumb to inertia and remain confined to ranges. The risks also increase for sudden breakouts and major trend reversals. Aggressive speculators such as hedge funds exploit reduced liquidity to push markets past key technical points, which forces other market participants to respond belatedly, propelling the breakout or reversal even further. By the time the holiday is over, the market may have moved several hundred points and established an entirely new direction.

Just because you’re enjoying an extended holiday weekend or a summer holiday in August doesn’t mean you’re not exposed to unexpected risk from higher volatility in holiday markets. You are – and you need to factor liquidity conditions into your overall trading plan.