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Understanding how to trade off these levels is absolutely critical. After all, the ABCs of technical analysis orbits around finding and exploiting these levels.
One of the typical pitfalls aspiring traders fall victims of is the failure to select the right price location to trade off, ensuring the prospects of enough risk-reward, and most importantly, do it in a consistent manner.
For big institutions and traders with a need to fill large orders, finding pockets of enough liquidity is absolutely essential. A market’s liquidity has a big impact on how volatile the market’s prices are. When these big players take positions in the market, they obviously aim to be filed at the best possible price. However, given the size of their positions, they need to find enough counter-forces to fill their orders, and here is the key, with a minimal amount of slippage. If a big player were to enter the market at an area of low liquidity, the volatility it would create would have a negative impact on the average price it gets. Lower liquidity usually results in a more volatile market and cause prices to change drastically; Alteatively, if the same trader were to enter a trade at an area of much higher liquidity, it usually creates a less volatile market in which prices don’t fluctuate as drastically, therefore ensuring a better average price for the entire position aimed to enter.
So, where do we find these levels? Where stop-loss orders are placed. Where do you think the old fashion concept of “stop-loss hunt” comes from? From the necessity that large players have to enter the market in areas of liquidity as they aim to accumulate major positions. These areas will always attract interest as that’s where pockets of liquidity exist, hence allowing them to get the best average price by reducing the risk of slippage.
The creation of a liquidity level comes as a result of an initial imbalance of supply/demand, which forms what we popularly know as a swing high or swing low. As more players take positions in the market, these are levels where market participants will use as a historical reference to place their stops. When the levels are then re-tested, a decision will be made. The binary outcome here can be a breakout of the level or a reversal back to the mean.
As a rule of thumb, unless the rejection makes it to a 50% retracement of the previous high/low, be in high alert of a low-quality liquidity level; the more vigorous the rejection of a level, the more chances it has of holding on a retest. Personally, I always like to see a rejection that leads to a structure breakout via a new cycle high or low. Other factors such as confluence, market conditions (risk on/off), market structure in higher timeframes, economic data, will also play a role in determining if the area will hold or fold, and you definitely want to account for all these elements too as part of your plan. However, the power of retesting an area of liquidity that had previously resolved into a successful market structure breakout, as I will show in an example below, tends to be a solid edge to exploit.
Other nuances one must be aware of when trading levels of liquidity include factoring in the time. If the separation between the creation of the liquidity area and the first retest comes after an excessive number of days/weeks (depending n the timeframe you trade), the level may not hold the same weight as it used to as the market context evolves and orders get pulled. At the same time, if you find two or more liquidity levels nearby — clustering of multiple levels of interest — , market participants will tend to place their stop loss orders at the most extreme level, so be aware of that.
To properly illustrate a level of liquidity where an opportunity to buy or sell may be present, simply draw a horizontal line from the latest wick or swing high/low and extend it all the way until it intersects with price again.
In this EURUSD hourly chart I present below, I randomly selected over a month worth of trading the EURUSD, with a blue line drawn if the liquidity level led to a break of the market structure (via higher highs or lower lows) or a red line if the retest of the liquidity level occurs amid a failure of a break in market structure. I assume an entry strategy based on trading off liquidity levels for a 2:1 risk reward with a stop half the size of the previous swing low/high (makes it more difficult to reach the stop before an opportunity to move to break even), a move to break even at 1:1 (it comes down to one’s own discretion), and with the pre-condition of a previous breakout of the market structure by printing higher highs or lower lows in the hourly chart.
By the end of the exercise, it should be abundantly clear how engaging in buy/sell trades with the pre-condition of a breakout of a market structure carries much greater chances of success (blue lines) as opposed to entering against the dominant market structure (red line). If you had only traded at the liquidity levels in blue, as I initially suggested to maximize one’s odds of success, it would have led to potentially 6 winners for 2:1 risk reward and 1 loser. Combine additional factors of confluence such as trading with the dominant market cycle in higher timeframes, aligning with fundamentals, a mechanical risk management, awareness of risk events, and this might well be a strategy that may suit your style. It’s now your time to find out, through your own backtesting, whether or not this is a methodology worth exploring further to make it your own. Hopefully, this exercise awakens the curiosity within you, especially if you are a looking to expand your trading arsenal.