By: Avramis Despotis, Founder & CEO, Tradepedia
As a trader, you need to be aware of certain notions in the markets. These notions can affect your trading significantly, especially during volatile market conditions. To make better trading decisions, the three concepts you need to be aware of are liquidity, slippage and swaps.
Does liquidity really matter?
Market liquidity refers to a market’s ability to buy or sell an asset quickly and without significantly changing its price. Liquidity is a crucial element of any financial system. Liquid markets are characterized by high volume and assets can be traded without significantly influencing the price. Non liquid markets are characterized by low volume and assets cannot be traded without influencing the price.
The forex market is the most liquid market in the world. The US stock market’s average daily turnover is$220 billion, while the forex market average daily turnover is $5.3 trillion. Liquidity fluctuates as markets across the globe open and close, with the period from 13:00 to16:00 GMT being the most liquid where London and New York will both be active. Liquidity is different for each currency pair, but EUR/USD, USD/JPY and GBP/USD remain the most traded pairs and witness the highest volumes. While a liquid market is known for its steady movements and fixed prices, illiquidity can lead to high volatility and price slippages.
When does price slippage hurt?
Slippage is the difference between the price you expect to pay and the actual price at which the trade is executed. It is more likely to occur when liquidity is low. This may also be the case during news events or due to a lack of either buyers or sellers. Slippage can sometimes go against you and sometimes it can go in your favour. If you place a trade to buy the EURUSD at 1.1950 and the trade gets executed at 1.1960, the slippage is 10 pips against you. If, on the other hand, you place a trade to sell the EURUSD at 1.1900 and the trade gets executed at 1.1905, the slippage is 5 pips in your favor.
Simplifying the concept of swaps
When you trade forex or CFDs with leverage, you are either borrowing or lending an asset. For this reason, interest is paid on the borrowed asset and is earned on the purchased asset. This is called swaps. Consequentially, as a trader you must pay interest on the asset that you will borrow and earn interest on the asset that you will buy. A rollover fee or ‘swap’ is charged when the trader keeps an open position overnight. The rollover or swap rate is the interest rate differential between the two currencies of the pair being traded. If the interest rate on the lent asset is higher than the interest rate on the borrowed asset, the trader receives swaps. When you buy USD/JPY, in essence, you borrowed yen to buy dollars. If we assume that the interest rates in Japan are0.25% and 2.5% in the USA, the trader will earn2.5% per year on the dollar and would pay 0.25%per year on the Japanese yen. To calculate the swaps, simply multiply the traded amount by the difference in the interest rates. So, for a long position of $200,000, the trader will earn $12.32 every day. Whenever the rate on talent asset is lower than the interest rate on the borrowed asset the account will bear a rollover debit.
When you sell USD/JPY, in essence, you borrowed dollars to buy yen. Now if we consider a short position of 200,000 USD/JPY, the trader would pay $12.32 every day. Although the market is closed on Saturdays and Sundays, banks still calculate interest on positions held over the weekend and therefore, positions held after Wednesday 22:00 GMT will be charged the swaps for three days.
