How to Determine FOREX Liquidity
Liquidity is one of the best friends traders have because it provides enough buyers and sellers to allow traders to make transactions when they want to and at prices close to what they expect. If you are a foreign exchange -- or Forex -- trader, ample liquidity reduces gaps in prices to make it easier to apply technical analysis and manage risk. The Forex market offers attractive liquidity, but it has some quirks traders must prepare for.
Hard to Measure
- It is impossible to measure exactly how much liquidity the Forex market has. While many stocks and commodities trade on an exchange and all trades are reported to a central office, Forex trades are conducted over the counter between individual brokers or institutions. The broker who handles a trade will offer software that shows liquidity in the trades made by that broker and even trades reported by other major players. Traders can estimate liquidity by noting the spread between buy and sell offer prices and the change in price between trades. Small spreads and changes in price indicate high liquidity.
Ticks and Spreads
- Brokers commonly express liquidity as an average of the past 24 hours, with the average of that period taken to be 100 percent. For example, an increase of 5 percent in current liquidity yields a reading of 105 percent. Average liquidity is calculated by dividing the number of ticks -- a measure of the time between trades and the number of trades in a period -- by the average spread. Heavily traded currencies show hundreds of ticks per minute, while lightly traded pairs might show one per minute or hour. The spread is the difference between what a buyer bids and what the seller asks. A small spread indicates high liquidity, with many buyers and sellers.
Conventional foreign currency trades (also called forex or FX) involves buying currencies using very low margin requirements. This offers large potential profits, but means each trade carries very high risk. Traders purchase FX options to reduce risks for other market positions or as stand-alone trades in which risk is limited to the premium paid for the option. FX options confer the right to buy one currency with another at a stated price for a specific period of time. Since you buy the first currency by selling a second currency, FX options are always simultaneously buy (call) and sell (put) options.
Things You'll Need
- FX trading account
- Study the workings of the foreign exchange market before you risk your money. Learn how major economic factors like inflation, trade deficits, and monetary policy affect currency rates. You must also gain an understanding of the "technicals," the short term trading patterns that are essential clues for successful FX trading. It's a good idea to open a practice forex trading account. Many forex brokers offer these accounts free of charge. You use real trading software and market information to learn FX trading "hands-on" without risking real money.
- Open an account with an authorized forex broker. In the United States, forex brokers are primarily authorized by the National Futures Association and must be in compliance with their business and ethical standards. Make sure the broker you choose offers FX options (not all do). Consider opening a "mini" account that allows you to trade small amounts of currency to start. Regular accounts generally require initial deposits of around $2,000. Mini forex accounts may be opened for $100 or even less.
- Choose the type of FX option you want. Traditional options allow you to buy one currency of a pair with the other currency of the pair at a guaranteed exchange rate called the strike price until the date the option expires. If the currency exchange rate moves in your favor, you can exercise the option and then sell the currency on the market at a profit. Single payment options trading (SPOT) options work differently. When you buy a SPOT option you propose a scenario. For example, you might predict that euros will move from $1.25 to $1.30 per euro within 2 weeks. If your prediction pans out, you automatically receive a payoff.
- Enter the currency you want to "go long" on (that is, the one you want the right to purchase) and the second currency (on which you by definition must "go short") of the pair into your trading software to purchase a traditional FX option. Ten enter the strike price and expiration date you want. The system will provide you with a premium quote (the price of the proposed option). If it's satisfactory all you have to do is accept the offered premium price.
