Large order traders are especially incentivised to see price 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).
Understanding 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 and market participants. Dealers include inter-bank dealers, prime and retail brokers, and market participants include Central Banks, hedge funds, large order traders, and retail traders.
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.As you probably know, the spot foreign exchange market is a decentralised market.
In other words, there is no central exchange through which trade orders pass, as there is in the equity and futures markets etc.. 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. 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 centralised source of pricing information. Prices are set by these inter-bank dealers, and these prices vary by fractional basis points. For example, one dealer may be offering (price to buy) EUR/USD at 1.0795 and another may be offering at 1.0799. A prime broker or retail ECN/DMA broker, who has credit relationships with multiple dealing centers, will take the offer they like best 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. However, that depth of liquidity available ebbs and flows throughout the day, and this is what it is so important to understand.
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. Liquidity is deepest when the London and New York trading sessions are simultaneously open, which is from 8 am to 11am est. During periods when only one trading session, or no major trading session is open, available liquidity at each fractional price level is significantly less. Therefore, large order traders that truly move the market are generally, in normal market conditions, unwilling to accumulate fresh long positions 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, price will tend to move in strong breakout movements, and price will oftentimes break above resistance and below support. However, during times of the day when liquidity is not as deep (1:30am to 3:00am est and 5:30 to 8:00am est, for example), you can expect 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 price break up to resistance or break down to support during a time of low liquidity, watch for opportunities to fade the momentum and trade back inot the previous dealing range.
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