Liquidity and volatility are two factors that frame the price action going on in any market. These two measures of the market work together in every market and, by identifying one, we have a good idea about the other. Understanding how they work together can help us understand what is happening in a market and give us a trading advantage.
What are Liquidity and Volatility?
The liquidity of a market is how easy it is to find a counterparty for your trade. Markets that simply do not have a lot of transactions typically have issues of liquidity. Exotic currency pairs, for example, are usually hard to trade because of the difficulty of finding a buyer for your sell order or a seller for your buy order.
In contrast, a major pair like EUR/USD, the most heavily traded currency pair in the world, is highly liquid. There are countless buyers and sellers at any given time. This means that transactions involving EUR/USD are typically quick no matter what time or day or night it is.
The volatility of a market is how much the price changes. A market where the price stays the same has no volatility. Volatility is important to anyone seeking to make a profit in the Forex market. When the price doesn’t move, there are no profits to be made. Increased volatility means increased risk due to the fact that when the price is moving in one direction, it could easily return to that price or move in the other direction. Extreme volatility is often seen as a negative, but some volatility is needed in order for a market to tradeable.
How are Liquidity and Volatility Related?
Liquidity and volatility are related by the fact that high liquidity leads to low volatility and low liquidity leads to high volatility. Prices in any market are an equilibrium between buyers and sellers. When there are plenty of buyers and sellers, the price may move up and down in small increments. But when there is a shortage of either buyers or sellers, one side has a distinct advantage.
That advantage allows them to dictate prices to the other party in the trade. If there are four sellers for every buyer, the buyer will have the advantage because each of those four sellers wants the buyer to buy from them. This excess supply (the sellers) meets demand (the buyer) and results in lower prices.
Conversely, if there are four buyers for every seller, the buyers will bid up the price of the seller in an attempt to get their order filled before others. This may be hard to see in the way that the Forex market functions, but these battles between the bid and ask between buyers and sellers are what dictate the price at any given time.
What to Watch for as a Trader
Given the rules above, we can infer that low volatility is a sign of high liquidity and high volatility is a sign of low liquidity. So, if we can determine the volatility, we will be able to recognize potential buying or selling opportunities. Indicators that are good for identifying volatility are the Parabolic SAR indicator, the Momentum indicator, and volatility channels like Bollinger Bands or Keltner Channels.
What each of these indicators does is tell us when the price has changed beyond some normal amount based on the historical price action of the market. The Parabolic SAR plots dots above and below the price. These dots form an arc that defines the curve that the indicator suggests the price will remain within. When dots appear above the price, there is a downtrend. When these dots appear below the price, there is an uptrend.
The Parabolic SAR was designed only to work in trending markets, to identify the market as trending independently using a MACD indicator or group of moving averages. When the indicator dots cross from below the price action to above the price action or from above to below, it indicates an entry signal.
The Forex momentum indicator that you get standard with MetaTrader shows the rate that the price changes. When the value given by the indicator is more positive, the more strength the uptrend will have. When the indicator is more negative, the stronger the downtrend. When the reading crosses from negative to positive or from positive to negative, it is an entry signal.
Volatility channels like Bollinger Bands and Keltner Channels use standard deviation to measure the significance of price changes. The higher the standard deviation, the more natural variability there will be in a market. Since the measure of variability is based on the price action of that particular market itself, these volatility channels are custom-made for each market.
When price reaches either the upper or lower band of either indicator, it suggests that volatility is far removed from the norm. These events are often treated as trend termination signals and signal that you should exit your trade but do not suggest a trend reversal.
Liquidity and volatility are two mechanics of markets that work together. When there is low liquidity, the price action responds with high volatility. When there is high liquidity, the ease of finding a buyer and seller results in low volatility. The Parabolic SAR, the Momentum indicator and volatility channels are volatility indicators that you can use to identify these conditions in markets.
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