Every trader needs to have a good understanding of both liquidity and volatility. Paper trading can provide a benefit to traders by allowing them to watch a market, getting in sync with its ebbs and flows to understand how it moves. Before trading a market, traders should watch it for at least a single month or two. This will not only give them a fair idea about the general volatility of the market but also help them learn to differentiate between a quiet market and a fast market.
Analyzing the market statistically before trading is another way to familiarize oneself with it. Both liquidity and volatility are not static and change over time. Therefore, any historical measurement of volatility is backward-looking by definition.
The statistical measurement of how an asset price moves, is called volatility. It involves using historical data for the analysis of the standard deviation of past moves. An asset tends to be riskier if it has higher volatility. It is usually expressed either as an annual percentage or as a histogram of returns. The higher the number, the more volatility the asset possesses.
Volatility is important because of its direct relation with position sizing. Because the risk of ruin is larger, a trader cannot trade as large a position in a more volatile asset. However, many experienced traders fail to understand this concept. Liquidity, on the other hand, is harder to measure than volatility.
Liquidity refers to the amount of slippage a trader can expect when they transact. For instance, the spread of the NZD/USD is 3 pips wide, while the spread for EUR/USD is 1 pip wide. This means that the liquidity of EUR/USD is substantially more than that of NZD/USD. As a trader increases their transaction size and/ or frequency, liquidity becomes an increasingly important consideration. The importance of liquidity increases as one manages more capital. However, when it comes to the forex market, it is arguably the most liquid market in the world.
Liquidity and volume have a very strong relationship. Currencies with high volume almost always possess better liquidity.
The above table shows the top 15 currencies by volume, along with their liquidity and volatility. It provides a good starting for grasping the concept of different currency personalities.
Liquidity and Volatility Vary by Currency
The currencies that are most suitable for trading possess both high volatility as well as liquidity. However, there is often a balance between the two. For instance, the major group has currencies which have excellent liquidity and volatility. On the other hand, the currencies in the EM currency group are usually volatile but are illiquid. Even from the table above, a weak but visible inverse relationship between volatility and liquidity is apparent.
Top 15 currencies – Relationship between liquidity and volatility
The G10 FX group of currencies is the most liquid and hence, ideal for traders. Trading currencies with less liquidity involve a lot of idiosyncratic issues. It becomes difficult and frustrating to trade currencies which are illiquid unless one works at a bank. Additionally, stop losses aren’t reliable for these currencies making risk management problematic.
Liquidity and Volatility Vary by Regime
Global asset markets have undergone periods of low volatility (e.g., 2005-2006, 2014, 2017) and high volatility (e.g., 1998, 2008,2011, and partially 2018). Volatility can change at a very fast pace and tends to move in sync with the volatility of the global asset market. However, there can be instances where FX markets are volatile while the stock market remains quiet or vice versa. Volatility tends to skyrocket when there is a disturbance after trending lower in slow motion.
Deutsche Bank FX Volatility Index(2002-2018) overlaid with equity volatility
In the above graph, we can see how equity volume and FX volume move up and down simultaneously, but not in sync completely. From the above graph, it is clear the volatility regimes can change rapidly and traders shouldn’t get used to anyone’s environment. They always need to be alert for any changes to market behavior and microstructure.
Liquidity and Volatility Vary by Time of Day
The developed market currencies and FX majors are heavily traded when the New York and London business hours overlap. In other words, it is 6:00 AM to 11:00 AM in New York and 11:00 AM to 4:00 PM in London. Some of the EM currencies are more liquid and active in their home time zone. For example, KRW is most active during business hours in South Korea. However, the best time to trade currencies, in general, is the LDN/NY overlap.
EUR/USD average hourly volumes by time of day – GMT – Feb to April, 2014
In the above chart, volumes are indexed and hence the y-axis has no label. It reflects each hour’s liquidity relative to each other. It represents the evolution of volume during the day for all the major currencies. The area between the two black lines represents the LDN/NY overlap. It accounts for more than half of the day’s foreign exchange volume, while just being a quarter of the day’s hours. This is due to New York and London’s status as the most active currency trading hubs in the world. Major events such as options expiry, WMR fix, and US economic data all take place during that period.
Key times to observe
If one takes a look at intraday volumes of the USD/JPY, one can get a more granular view of what actually happens when the above-mentioned events occur.
USD/JPY Average Intraday volumes (7:00 AM to 7:00 PM LDN)
In the above graph, 3 major spikes of volume occur: the first one at 8:30 AM NY with the release of economic data; the second one at 10:00 AM NY with options expiry; the third and last one occurs at 11:00 AM NY, coinciding with the WMR fix.
Conclusion
Both Volatility and Liquidity are essential for investors and traders to adapt their risk and position management to current circumstances. It also helps them to analyze the market statistically before they commence with their trading.