Ah yes, “liquidity”, everyone’s favorite trading buzz word these days, and for good reason too. It sounds catchy, makes you sound like you’re some financial wizard, but the truth is that liquidity is everywhere (in different concentrations of course), and it plays a huge role in making the markets move, especially in markets as heavily manipulated as Forex or stocks.
Liquidity is simply certain price points in which orders collect in the market and where an asset class is “liquid” – meaning that there are available orders sitting there ready to transact at that price. When smart money concepts or supply and demand traders refer to liquidity, they are usually talking about where orders are sitting, in anticipation of a BFI (Bank or Financial Institution) either taking those orders or seeking liquidity in the form of price action patterns. It should be noted that this is a more advanced concept, so if you’re brand new to trading or forex, be sure to check out our 4 part forex beginners guide.
Liquidity Can Be Thought of As Resting Orders In The Market
To help you better understand what liquidity is, I’ve put together some simple diagrams to really illustrate why we consider particular price action patterns as “liquidity” or a “build-up of liquidity” It’s not that the patterns themselves are liquidity, but more so that when a certain pattern in price emerges, it is by its very definition building liquidity and attracting liquidity in the market at key levels and price points.
Liquidity, in its simplest form, just a collection of orders sitting in the market, whether they’re limit orders, stop loss orders, stop limit orders, or a place where there is likely to be a concentration of market orders that will be executed when price gets near or interacts with certain levels of supply or demand in the market. For a better understanding of why price moves around in the market as it relates to liquidity, check out our article on what makes markets move.
Liquidity Helps Us Figure Out Where Price Will Likely Go Next
So, what use is liquidity to us traders? Good question. Liquidity helps us determine where price is likely to go next. Not on its own, but in combination with things like higher timeframe market structure (trend), supply and demand, and orderflow – we can get a good idea of where price will be “magnetized” to and use that information to help us form good quality trade ideas. After all, it’s our job as traders to capitalize on opportunities in the market by calling the market’s direction and catching a trade that moves in our favor in order to profit off of it.
Later in this article we’ll dig into all the different ways that we can use liquidity to give us a clearer picture of what the market is doing and how it’s being manipulated without solely relying on structure (which can be misleading at times, especially in rangey market environments, or on mid-timeframes). Using liquidity to decipher what the market is doing is counter-intuitive so it’s recommended to practice using it in conjunction with trend and supply and demand in order to read it effectively!
Liquidity Is Fuel For Movement In the Market
Again, this may seem counterintuitive but liquidity is actually necessary to fuel moves in the market. If you take into consideration the way highly liquid markets like the FX, indices, commodities, stock, and crypto markets operate, it makes a lot of sense. Highly liquid markets are typically manipulated by large banks, institutions, or whales that have the means to push the market around by absorbing buy or sell orders and proceeding to push the market around by flooding it with buy orders to cause the price of an asset or equity to go up, and conversely flooding it with sell orders to push the price down.
Since BFIs have enough capital to move prices around, it also means that they lack the necessary liquidity to get into meaningful position size without inadvertently pushing price away from their entry point, and consequently, getting a poor average fill on their position. This lack of liquidity results in orders not being filled at their desired price and thus slippage!
A Lack of Liquidity Can Create Volatility
Ever wonder why some cryptocurrencies or penny stocks in the U.S. OTC markets go through massive swings in price action for no apparent reason? Or why sometimes you’ll see gaps in price when looking at a particular instrument? It’s simple: Low liquidity in the market can cause price to move violently up, or down. Sometimes, an absence of liquidity in a market can actually cause prices to spike or fall at a rapid pace. While this doesn’t happen much in the FX market aside from when there are high impact news releases, it’s good to understand the how and why behind market movements so we can avoid things like slippage.
The Three Different Types of Liquidity
Structural liquidity is defined as liquidity that rests above major pivots in price action, but only when that pivot or structure point is responsible for breaking one or more levels of structure. The logic behind this is that if there is a clear level in which price pivots from, there will be a build up of buyer’s stop losses sitting below a level of pivot demand, and seller’s stop losses sitting above a level of pivot supply.
Without getting too into the nuances of this type of liquidity, this type can be grabbed (or swept) and used as a liquidity trap to aid them in building or off-loading a position in the market.
Alternatively, it can also be targeted and used by a BFI to fuel a move and help to push price in the direction they originally intended as to manipulate price in order to profit from a position they’ve built.
Buy Side Liquidity
Buy side liquidity is considered any build up that sits above a range or high where sellers stop losses (buy orders) and breakout trader’s orders (buy stop limits) are sitting, ready to be run and to fuel a momentary or sustained bullish movement in price. This is considered liquidity to “target” or “fuel the move”. Alternatively you can class targeted lows as BSL (buy side liquidity).
Sell Side Liquidity
Sell side liquidity is considered any build up that sits below a range or low where buyers stop losses (sell orders) and breakout trader’s orders (sell stop limits) are sitting, ready to be run and to fuel a momentary or sustained bearish movement in price. This is also considered liquidity to “target” or “fuel the move”. Alternatively you can class targeted lows as SSL (sell side liquidity).
How We Can Use Liquidity To Our Advantage as Supply & Demand Traders
As supply and demand traders it’s super important that we stay aware of where liquidity is being built so we don’t get caught in common traps that institutions and banks build to entice traders to engage with the market before it’s ready to go. By effectively reading liquidity in the market we stand a much better chance of catching the true moves on any given day by effectively hitching our accounts to the BFI’s intended move.
First let’s address the most common type of trap, bullish and bearish liquidity traps. These can simply be identified in the market on the mid to higher time frames as a clear sweep of a structural or pivot point of supply or demand that essentially tricked traders into both using the level that is swept as a POI, only to be swept out and see price move in the direction they predicted, and traders who expected the POI to fail and were trying to play a breakout from that level. See the diagrams below for a visual representation.
Liquidity As Inducement
Next we have liquidity that is used to induce people into a position early, only to get swept out, similar to the way liquidity traps use a swing point of supply or demand to entice traders to get into a position early, only to later get taken as liquidity by the BFIs.
In this case, you have a level of supply sitting below a nearby level of supply that gets swept as it taps into the one above before running bearish, or you have a level of demand sitting above another level of nearby demand that gets tapped into below it before running bullish.
Liquidity To Target
Last but not least we have liquidity to target, which we use in a way that is similar to using it as “fuel for the move”. In this case, we’re looking to see liquidity get run and continue in the direction it’s being run, not sweep and reverse. Again the logic behind liquidity to target and use for fuel is that BFIs have already built up a position and are now going to manipulate price to push it in the direction they intended so they can profit off of the position they’re in, before offloading it. This is the case for both longs and shorts in the forex market.
Liquidity, An Important Concept That Is Often Overlooked
In conclusion, we’ve explained what liquidity is, how it works, and where it sits from a mechanical stand-point, what purpose it serves in the market, and how it’s used by BFIs to build and offload positions – which is the whole reason behind the manipulation we see in the market.
While we went over the different types of liquidity, this article really only scratches the surface of how liquidity can be used to help us with analyzing the market effectively. The truth is, understanding and using liquidity to your advantage as a professional trader is a skill that requires a truly nuanced understanding of the market, plus experience with using it to understand where you should and shouldn’t be trying to get into the market.
Luckily, at Phantom Trading we cover these concepts in-depth and provide the support you’ll need to not only grasp them, but master them.
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Robert Castillo – Currency & Commodities Trader,
Financial Analyst, Writer & Editor.
Robert is a funded trader based out of Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading he enjoys producing music, mixed martial arts, and riding his motorcycle in the summer.