EXPLAINING LIQUIDITY IN SIMPLE WORDS

20 de mai.

Liquidity plays a vital role in shaping market prices, particularly among large market players such as banks, hedge funds, and other influential entities. These entities, often referred to as market makers, manipulators, and others, are driven by their pursuit of liquidity. In fact, liquidity is the foundation upon which successful trading is built, and it's where traders should begin their journey.


In the context of Smart Money Concepts (SMC), liquidity refers to the levels of asset price where multiple market participants have placed limit orders, stop orders, and liquidations. Stop orders are essentially reverse orders designed to mitigate losses by buying back positions that have gone against a trader's expectations. When a trader sets a Stop-Loss order, they're essentially trying to limit potential losses if the market moves against them.

The concentration of stop orders creates a gravitational effect, making it attractive for larger players to gain an advantage. By identifying areas with high concentrations of stop orders, big players can exploit these liquidity zones to collect profits from retail traders who are unaware of these market dynamics. As a result, the movement of prices from one liquidity zone to another is driven by the actions of these powerful entities, ultimately shaping the market landscape.


❓ HOW TO IDENTIFY LIQUIDITY ON THE PRICE CHART?

Before we dive into trading and trades, we must first identify obvious liquidity pools. These will be our closest target for the price to converge upon.
There are several types of liquidity in the market:

• Equal highs and lows (EQH/EQL), which mark significant turning points
  
• Swing structural points, including notable highs and lows that can be significant drivers of market activity
  
• Boundaries in sideways price movement, such as ranges or sideways trends, where liquidity is concentrated
  
• Trend movement, where liquidity tends to accumulate below or above the trendline
  

📊 SIGNIFICANT PRICE HIGHS AND LOWS

The SMC features six key extrema that significantly impact trading:
• The previous month's high and low values
• The previous week's high and low values
• The previous day's high and low values
• The current trading day's high and low values
• Equal highs and lows, which can be particularly significant in determining market trends


📈 Equal Highs (EQH) or Equal Lows (EQL) 📉

The double bottom or double top candlestick formation is a common indicator of a potential price reversal. When the price reaches these formations, it typically signals a change in direction, with the price moving in the opposite direction. For retail traders, equal highs and lows are crucial levels of support and resistance, prompting them to place stop orders at these levels. These levels act as a gravitational force, attracting large capital flows and creating a significant amount of liquidity.


When the price approaches these levels in reverse, it's not uncommon to see a cluster of stop orders forming, as traders anticipating a bounce from the level wait for the price to react. However, large players often take advantage of this expectation by executing stop-loss orders through a false breakout, ultimately triggering a price reversal.


💲 SIGNS OF A SUCCESSFUL LIQUIDITY GRAB

Let's consider a buy scenario as an example. Traders identify a strong low price, and large capital players recognize an obvious accumulation of liquidity at this point. When the price returns to this low and breaks it, but without forming a full candle, the price closes above the broken low. To better understand this concept, let's examine the schematic representation of liquidity grab in buying scenario.


Liquidity is a top priority for big players, known as “smart money”. A significant player is actively seeking to find it to secure their position. The reason is that if they were to open trades without sufficient liquidity, they would be exposed to price slippage, as there may not be enough buy or sell orders in the market to execute their trades efficiently.


🔎 IS IT A LIQUIDITY GRAB OR NOT?

Distinguishing between a liquidity grab and a breakout of market structure is crucial, as they share similarities. In the case of a liquidity grab, the price fails to close at an important structural highs or lows, instead takes liquidity forming long tailed candles.


In contrast, a breakout of the structure sees the price breaks and closes above or below new level. Notably, liquidity grab often precedes a price reversal, whereas breakout of the level typically perpetuates the underlying trend.


📍 TREND LIQUIDITY

In a clear trending market, liquidity forms in both directions, at the lows and highs. Let's take a closer look at a downward trend movement. When we see the price moving downwards, we initially take liquidity at the lows, which has been building up since the price reached its maximum. Then, we take liquidity at the minimum, creating a natural flow.

At the highs, we deliberately leave liquidity on purpose, allowing it to build up and eventually be taken away naturally. The liquidity at the lows acts as a price magnet, attracting a large player who begins to accumulate their position. In some cases, the price may form equal lows, known as a double bottom in technical analysis. This signals to traders that it's time to enter a trade, and they place stop losses above these levels. At this point, a major player manipulates the price, taking this liquidity and reversing the trend. The first target is then the trend highs, where liquidity is located – it was left earlier to be taken away.



📝 HOW TO WORK WITH LIQUIDITY?

When working with liquidity, it can be a valuable tool for entering a trade, as well as helping to set a stop loss by avoiding arbitrary price levels. Instead, you can use liquidity to guide your trading decisions and create more informed stop-loss strategies. Moreover, take profits can also be placed on liquidity levels, as the price is constantly moving between these levels, making it essential to take profits before they're taken away.


💎CONCLUSION

The benefits of liquidity analysis extend to any time frame, whether it's weekly, daily, or even 1-minute charts. This means that liquidity can be effectively applied to analyze forex market, indices, cryptocurrencies and shares of companies for investment purposes, making it a versatile tool for traders and investors alike.

Traders, If you liked this educational post🎓, give it a boost 🚀 and drop a comment