Understanding the Meaning of Illiquidity in Forex Trading

Illiquidity is an important concept to understand when trading forex—unlike a market with high liquidity, which is quite active, a market with low liquidity is inactive.

Illiquidity refers to the inability of a market to convert an asset into cash quickly. In forex trading, illiquidity means that it’s hard to get in or out of a position due to low volume (which could happen due to macroeconomic events), causing the price to move unexpectedly. Sometimes you even might not be able to close your positions at all.

Illiquidity can have serious consequences due to limited market depth, which can inadvertently cause price volatility. It primarily has an effect on three aspects of trading:

• Wide bid-ask spreads: When there’s low liquidity, the difference between the buying and selling prices of a currency pair, i.e., the bid-ask spread, increases. This is because most of the time, market makers have to compensate themselves for having to maintain a large position in an illiquid market.
• Increased slippage: As liquidity decreases, the brokerage’s ability to complete a transaction diminishes. It is more likely for your order to go unfilled or be filled at an undesired price level.
• Disjointed price action: When trading in an illiquid market, you could experience significant price gaps or disjoints that happen when a large order causes the price to suddenly jump. Monitoring liquidity levels and being wary of entering positions at times of low liquidity is crucial, especially for traders with larger accounts, as even minor price action in the market can cause major losses in their positions.

A trader should always be aware of current market liquidity levels before entering a position. It’s also wise to use a brokerage with access to different liquidity sources, as this helps to provide the best execution when trading.

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