An Illiquid Currency Strategy involves trading currencies that are typically low in volume and not actively traded in the global markets. These currencies tend to have wider spreads, greater volatility, and larger price swings, creating opportunities for profit through market inefficiencies. However, they also pose higher risks, including potential liquidity traps and large slippage during trade execution.

This article will explore how to construct a successful Illiquid Currency Strategy, the inherent risks, and how professional traders manage them to capture returns in these high-risk, high-reward markets.

Why Trade Illiquid Currencies?

• Higher profit potential: Illiquid currencies can experience large price swings due to low market depth and fewer participants.
• Market inefficiencies: With fewer market makers, illiquid currencies often trade at mispriced levels, creating arbitrage opportunities.
• Lack of competition: Fewer players in the market can lead to better execution opportunities for informed traders who can manage liquidity risks.
• Carry opportunities: Many illiquid currencies offer attractive carry trade setups due to high interest rates, which may be more volatile but can deliver high returns if timed correctly.

However, the major downside of trading illiquid currencies is the high transaction cost, slippage, and difficulty in exiting positions, especially during periods of market uncertainty.

Core Components of an Illiquid Currency Strategy

1. Currency Selection Criteria

• Liquidity and Spread: Focus on currencies that are not widely traded but still have enough liquidity for profitable trades.
• Interest rate differentials: Often, illiquid currencies have higher interest rates, which creates the potential for carry trades.
• Fundamental analysis: Illiquid currencies are particularly sensitive to macroeconomic events or policy changes in their home countries, providing a rich source of alpha.
• Political stability: Currencies from politically stable countries are less risky to trade, even if they are illiquid. Countries with high geopolitical risks can cause sharp, unpredictable moves in illiquid currencies.

Example:
The Zambian Kwacha (ZMW) and Kenyan Shilling (KES) may be examples of currencies that can be attractive to trade in specific economic conditions due to their carry potential, but they tend to exhibit large swings in response to political or economic news.

2. Volatility Management

• Illiquid currencies exhibit higher volatility due to low liquidity and large price movements.
• Use volatility-adjusted position sizing to ensure the portfolio’s overall risk is controlled.
• Use options or futures for hedging positions when volatility spikes, especially around political events or economic reports.

Example:
For a position in the Turkish Lira (TRY), increase position size during low-volatility periods and scale back during high volatility to manage risk effectively.

3. Timing and Market Timing Tools

• Trade during market hours with the most liquidity: This typically occurs during major market overlaps such as the London/New York session. Trading illiquid currencies during these hours can help minimise slippage and execution risk.
• Be cautious during major political or economic announcements: These can lead to erratic and unpredictable price movements in illiquid markets.
• Use limit orders: To control slippage, especially when entering or exiting positions in illiquid currencies.

Example:
If trading the Vietnamese Dong (VND), placing limit orders at key support and resistance levels can help avoid sudden market shifts and slippage, which is common in thinly traded markets.

4. Risk Management and Position Sizing

• Due to the higher volatility and wider spreads, illiquid currencies require more careful position sizing.
• Implement tight stop-losses to protect against large adverse price movements, as illiquid currencies can reverse quickly.
• Be aware of liquidity traps: Avoid overextending yourself with large positions that might be difficult to exit due to limited market participants.

Best practice:
Limit your position size to 0.5-1% of your portfolio for illiquid currencies to manage risk exposure and allow flexibility for other investments.

5. Liquidity Risk Monitoring

• Track bid/ask spreads to gauge potential market impact before entering trades.
• Monitor liquidity events, such as central bank interventions or policy changes, which can cause sharp, unpredictable shifts in illiquid markets.
• Watch market depth: Use tools like Level II quotes or bid/ask data to ensure there is enough liquidity to enter or exit trades without causing excessive slippage.

Example:
If trading a currency like the Nigerian Naira (NGN), where liquidity can dry up quickly, you would need to be cautious of large moves or out of hours market events that can cause liquidity to vanish.

6. Long-Term Positioning and Carry Trades

• Illiquid currencies often offer higher yield opportunities, making them attractive for carry trades.
• Focus on holding positions over a longer time horizon (months rather than days) to capture carry premiums while managing downside volatility through volatility-adjusted risk and diversification.
• Hedge long positions with options (for example, deep out-of-the-money calls or puts) to mitigate downside risks during periods of political instability or global shocks.

Example:
A carry trade in Brazilian Real (BRL) against a low-yielding currency like JPY could yield attractive returns if held over the long term, while protecting the position with out-of-the-money options for tail-risk protection.

7. Monitoring Political and Economic News

• Illiquid currencies are particularly sensitive to geopolitical events and domestic political instability.
• Keep an eye on political elections, government changes, or trade negotiations, as these events can lead to sharp price movements.
• Tailor your strategy around event-driven risks by using macro data analysis or tools that track key political events (e.g., election cycles, parliamentary votes).

Example:
During Brazilian elections, the Brazilian Real (BRL) could see large fluctuations based on expectations regarding future economic policies. Keep up-to-date with political risk indicators.

Risks and How to Manage Them

Risk	Mitigation
Large spreads and high slippage	Use limit orders and trade during liquid market sessions
Sudden volatility spikes	Position sizing adjustments and options hedging
Liquidity risk	Avoid large positions and monitor market depth
Political instability causing abrupt price shifts	Active monitoring of news and events, limit exposure during election periods

Advantages of Illiquid Currency Strategies

• Potential for higher returns due to wide bid/ask spreads and larger price swings.
• Carry trade opportunities with potentially higher yields compared to more liquid currencies.
• Market inefficiencies: Fewer players can mean more opportunities to exploit mispricing.
• Diversification: Access to markets and currencies that are often overlooked by larger institutional traders.

Conclusion

An Illiquid Currency Strategy requires a high level of expertise and risk management due to the inherent volatility and low liquidity of the currencies involved. When executed carefully, this strategy offers the potential for significant profits, particularly when capturing carry opportunities or event-driven movements. However, the risks associated with illiquid currencies demand careful position sizing, timing, and constant monitoring to manage potential losses effectively.

To learn how to execute strategies in illiquid currencies, manage liquidity risks, and capture profitable opportunities through event-driven trading, enrol in our expert-led Trading Courses, designed for traders looking to master emerging markets and political risk trading.