What you'll learn
- Define liquidity and explain who provides it
- Connect liquidity to spread, slippage and gaps
- Recognise when a market is liquid and when it is not
Who provides liquidity
Market makers at banks and specialist firms quote two-way prices continuously, standing ready to buy or sell. Every other participant adds to the pool whenever they place a resting order. The result is a ladder of bids below the current price and asks above it, called the order book or depth of market. A large order eats through several levels of that ladder, and the further it has to go, the worse the average price.
Liquidity and cost
- Deep liquidity means a tight spread, because many quotes crowd around the current price.
- It means little slippage, because your order is filled at or near the price you saw.
- It means orders fill instantly rather than partially.
- Thin liquidity produces the opposite: wide spreads, slippage, and sometimes gaps where price jumps over a level without trading at it.
When liquidity dries up
Liquidity is not constant. It thins in the hour after New York closes, over public holidays, at the moment a major news figure is released, and on any day when banks pull their quotes because they are unsure what a price should be. The 2015 Swiss franc move, when the Swiss National Bank abandoned its euro cap and EUR/CHF fell by a fifth in minutes, is the extreme case: there was nobody on the bid, so stops filled thousands of pips below where they were placed.
What a retail trader does about it
Trade the majors during their busiest hours if cost matters to you. Avoid entering positions in the seconds before a scheduled release. Assume a stop loss can fill worse than its price in a fast market, and size positions so that a bad fill is an annoyance rather than a disaster. And notice that a broker's advertised spread is measured when liquidity is deep; the spread at 22:00 UTC on a Friday is a different number.
Key takeaways
- Liquidity is created by participants quoting and dealing; the majors have the most.
- Deep liquidity means tight spreads and reliable fills; thin liquidity means the reverse.
- Liquidity thins at predictable times and vanishes in shocks.
- Size and time your trades with that in mind.
Knowledge check
Trading forex, CFDs and other leveraged products carries a high risk of losing money. This lesson is general education, not advice. Risk disclosure.