Shifting Liquidity Conditions Can Increase Currency Trading Volatility - dummies

Shifting Liquidity Conditions Can Increase Currency Trading Volatility

By Kathleen Brooks, Brian Dolan

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 Asia-Pacific trading session, which accounts for only about 21 percent of global daily trading volume.

Japanese, Chinese, or Australian data or comments from regional finance 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 and interest, currency rates are prone to drift in narrow ranges, but are also 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 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 these 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/New Year 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 doesn’t mean you’re not exposed to risk from higher volatility in holiday markets. You are — and you need to factor liquidity conditions into your overall trading plan.