One of the outstanding features of trading the forex market is its liquidity. According to the latest Bank of International Settlements (BIS) triennial report, covering the period 2004–2007, that liquidity has reached monumental proportions, growing 71% in the last three years and reaching U.S. $3.2 trillion in average daily turnover this past April.

Forex market liquidity is advantageous to traders in several ways. The most obvious advantage is there’s never a need to wait for orders to be filled; with so many buyers and sellers to hand, trade execution is almost instantaneous.

This liquidity also ensures there’s a financial cushion to soften the impact of large trades. Major market players sometimes initiate trades of US$300 million or more; the price alteration that would be expected from so much money entering the market at one go is mitigated by the cushioning effect of the large amount of money that’s already there.

Such an effect is most noticeable in EUR/USD. This currency pair accounts for 27% of each forex trading day’s volume, or US$864 billion in trades per day. That’s such an enormous amount of liquidity that, even when major trades are initiated, the price rarely moves more than a few pips in response. This is the cause of the pair’s well-known tick-by-tick movement, as opposed to the multiple pip jumps of less liquid pairs such as GBP/USD or USD/CHF.

However, toward the year’s end, that legendary liquidity tends to shrink. Trading institutions slow down for the holidays with staff on vacation, and major players begin to close their books in preparation for sending them off to the tax accountant. The amount of turnover decreases as a result, in some years dramatically.

The forex trading market suffers from illiquidity at other times as well, for example, other holidays or traditional vacation periods such as Easter or August. Another usual occasion is the last week of March, a common financial year’s end.

The result of this lack of liquidity is that large moves by the major forex trading players can be expected to have a greater impact on the charts. When large sums of money enter the market at such times, there’s less of a cushion to soften that financial blow, and currency pair prices will move more sharply in response.

Particularly in December and early January, traders can expect to see more volatile movements on the charts. With prices already jittery from the fallout over the ongoing credit crisis, this year may be especially dramatic.

For this reason, technical analysis becomes less accurate during illiquid periods. In particular, moving averages, Bollinger bands, and other indicators which rely on price action will need to factor in wider swings than normal. This can be accomplished either through cautious usage by the trader or through increasing the amount of input into the indicator’s calculations (e.g., using a 20-day moving average rather than a 10-day). Although greater input will smooth the effects of illiquidity, it will also lower the sensitivity of the indicator, making it less useful in short-term trading.

Perhaps this is the reason so many of the major players do not trade during the month of December, making this another of forex trading’s self-fulfilling prophecies.