Posted by forex at 7:31 AM
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1. Determine market depth of open trade orders. Your Electronic Communications Network, or ECN, brokerage account provides a Depth of Market, called DOM, window that displays all FOREX interbank open bids and asks, with volume, for a currency pair. The higher the stack of open bid and ask volumes, the more liquid the pair. A highly liquid currency pair will see many bids and asks clustered around the last executed trading price -- these are limit orders, which won't execute at a price less favorable than the one on display.
2. Determine the bid/ask spread for the currency pair. The smaller (or 'tighter') the bid/ask spread, the more liquid the currency pair. The difference between the lowest ask and the highest bid is the current bid/ask spread. It is available from a DOM window. FOREX spread is measured in pips -- .01 of 1 percent -- where a tight spread may be a half of one pip, and a loose spread may be five or more pips, depending on the currency pair.
3. Determine volatility. A highly liquid market is resistant to wild price swings. Conversely, when liquidity decreases, FOREX volatility increases. An abrupt increase in volatility is readily apparent by prices that suddenly trend or exhibit a deepening up-and-down zigzag movement. There are a number of technical indicators that quantify current volatility; most ECN platforms provide the data necessary to calculate these indicators.
4. Monitor central bank policy. Intermediate-term FOREX liquidity trends are in part determined by central banks: when they purchase short-term debt instruments, foreign currencies or other assets, they are injecting local currency liquidity into the market. Conversely, the sale of assets by central banks tends to dry up liquidity in the local currency. That being said, central banks have little power to fundamentally alter FOREX liquidity.