End Year Market Illiquidity

Does year end illiquidity really cause technical analysis to become less accurate?

In short, yes.

One has to remember that one of the basic requirements for technical analysis is that there is mass psychology. Mass psychology means that all market participants are active, reacting to price movement and generating turnover which in turn contributes to the structure of classic chart patterns. On average it is estimated that daily Forex turnover is in excess of US$ 2 trillion, by far the largest of all global financial markets.

By the middle of December many players are beginning to close their books for the year resulting in a much lower level of turnover. This decline in turnover means that large trades tend to have a greater impact than in normal trading volumes. Market traders prefer to remain square or carry small positions since they do not want to suffer losses from such abnormal movements, effectively increasing the level of illiquidity.

Let me give you an example of a market with normal levels of liquidity. Some years ago the trading room I worked in heard of a large transaction in Dollar-Canada of around US$300million. This sort of size, however well it is handled by a trading desk is likely to cause some movement and one might expect at least 25-40 points. The Treasurer took a position of US$10 million in the direction of the order and indeed the rate edged higher by 10 points. Before being able to close the position the rate suddenly reversed and dropped by 50 points.

What had happened? By coincidence there was an order for US$500 million in the opposite direction. It highlights how there is no such thing as market manipulation in Forex and no such thing as insider trading.

I therefore argue that in comparison to other financial markets which have a much smaller daily turnover and are subject to insider trading and the ability of one large participant to have a more significant affect on price direction, Forex is probably the only true market which is perfect for technical analysis. It truly reflects mass psychology.

Returning to the subject of end-year illiquidity, what happens to technical analysis?

Well, I work heavily with Fibonacci and harmonic relationships which I utilize to help identify which movements are related. These produce both retracement targets in corrections and also projected targets for future movements running from 5 minute charts through to monthly charts. All shorter term movements should work within the framework of the longer term movements. During December and the early part of January is that these relationships get pushed out of whack. The wave structures are more erratic and without easy to identify relationships it is difficult to recognize which moves are related.

This most certainly occurred over the last two week in December in particular and it is only this week that there is a stronger build up of more normal wave movements. All in all these do fit into the daily and weekly moves but given that these longer term charts can see a variety of patterns the limits of the support and resistance are wider and the stronger accuracy of normal markets becomes more vague.

Thus, when considering your own analysis and trading do be aware of the attendant risks during these illiquid periods. December and early January are the most affected but there can be similar dips in liquidity, but not quite so extreme around major holidays or financial year ends such as end March, Easter and quite often in August. Try and keep your positions during these periods to the minimum and trade less.