Large order traders in the Forex market are especially incentivized to see prices move into areas of strong order flow. Essentially, the stronger an area is from a technical perspective, the more (in number/confluence) and larger (in volume) the orders will be in that specific price area (which is, in turn, providing liquidity pool FX).
Liquidity and the cost of execution must be understood in order to capture the essence of this article. Basically, the spot foreign exchange market is a continuous search for liquidity between dealers (liquidity pool FX providers) and market participants. Dealers include inter-bank dealers, prime and retail brokers, and market participants include Central Banks, hedge funds, institutional investors, large order traders, and retail traders. Simply put, brokerage firms connect the first group to the second.
The Importance of Liquidity in the Forex Market
This search for liquidity goes on around the clock. If you understand how liquidity ebbs and flows around the 24-hour cycle, you will have an edge and understanding of why price moves the way it does during certain times of the day. Armed with this knowledge you can construct your strategies accordingly and identify the best time of the day to trade the markets. As you probably know, the spot foreign exchange market is a decentralized market and the most liquid market of all.
In other words, there is no central exchange through which trade orders pass, as there is in the equity and futures markets that have centralized exchanges. Instead, the market is simply an informal connected web of inter-bank dealers and large money centers around the world which have credit relationships with one another through interbank connections and retail trading platforms. As these various inter-bank dealers and large money centers wake up for business each day, liquidity and transaction volume shifts through different regions of the world.
Since spot FX transactions are executed and settled off-exchange, there is no regulated and centralized source of the pricing information. Prices of assets are set by these inter-bank dealers, and these prices vary by fractional basis points. For example, one liquidity provider may be offering (price to buy) EUR/USD at 1.0795 and another may be offering at a market price of 1.0799. A prime broker or retail ECN/DMA broker, who has credit relationships with multiple dealing centers and liquidity pools, will take the offer they like most competitive quotes and pass it on to their client (you, the trader).
Now, during liquid times of the day under normal market conditions, there will typically be deep pools of liquidity at every fractional price that provide traders with the best available prices. However, that depth of liquidity available ebbs and flows throughout the day, and this is what it is so important to fully understand.
Liquidity Pool FX By Session
There are three primary trading sessions in the FX market:
- The London Session
- The New York Session
- The Tokyo Session
Liquidity is deepest when two of these sessions are open at the same time. For example, liquidity is deepest when the London and New York trading sessions are simultaneously open, which is from 8 am to 11 am est. This is also the hours at which key economic data is being released. During periods when only one trading session is open, or no major trading session is open, available liquidity at each fractional price level is significantly less and the trading activity is lower. Therefore, large order traders that truly move the FX market are generally, in normal market conditions, unwilling to accumulate fresh long positions and big trades above key levels of resistance or fresh short positions below support.
One basic practical application you can take from this article is this—during times of deep liquidity, the price of currencies will tend to move in strong breakout movements, and the price will oftentimes break above resistance and below support. However, during times of the day when liquidity is not as deep (1:30 am to 3:00 am est and 5:30 to 8:00 am est, for example), you can expect the price to not break above areas of key resistance or below areas of key support because of the increased cost of execution for large order traders (the market movers).
Therefore, when you see the price of an asset break up to resistance or break down to support during a time of low liquidity, watch for trend opportunities to fade the momentum and trade back into the previous dealing range.
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