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Based out of Auckland, New Zealand, we bring an institutional trading experience to the retail market.
Mark O' Donnell
 · 
Research Analyst
October 15, 2020
 · 

Trade Tactically With Liquidity Pools & Stop Orders

Have you ever been stopped out, just to see the price reverse from that very same level? Don’t worry, you’re not alone.

Many traders tend to place their stops in the same types of places, without sufficiently weighing the fact that they are incredibly easy and worthwhile to hit. In the grand scheme of things, these stops end up becoming little more than useful liquidity pools for larger players with the firepower to influence the market’s direction.

What Is Liquidity & Why Is It Important?

If you want to buy EURUSD at 1:1000, you need someone to sell it to you at 1:1000. The same applies in reverse: if you are selling, you need a buyer. This is just the nature of the market.

To keep things simple, saying an asset is “liquid” means it’s easy to find a counterpart. The opposite is “illiquid,” meaning it’s difficult to find a counterpart. Here’s Bill Lipschutz, discussing what liquidity means to him:

"I'm short the dollar and I've misjudged my liquidity in the market, I've tried to hold the market down, but it's not going to work. And I can't buy them back." “All I wanted to do was to make it through to the Tokyo opening at 7 P.M. for the liquidity. If you really have to buy $3 billion, you can do it in Tokyo; you can't do it in the afternoon market in New York - you can't even do it on a normal day, let alone on a day when major news is out.”

– Bill Lipschutz, New Market Wizards.

"Liquidity pools" are levels at which price frequently "makes a decision" as many orders hit the market. They are, so to speak, intersections of orders. This helps with managing open trades, initiating new trades, and adjusting stop losses.

While it’s impossible to avoid losses in the market, it is important to understand the where and why of the market’s reaction.

How To Avoid Dumb Mistakes

The first order of business when talking about stops is to make sure we aren’t placing them too close to the market. Otherwise, we risk getting stopped out too frequently on volatility alone. Here are some reasons why traders get stopped out:

  • Doing the right thing (but running into timing issues);
  • Because we were unlucky (rogue spike: luck has a role in trading);
  • Doing the wrong thing (fighting evident flows); and
  • Because we have no idea what we are doing (experience issues).

We want to avoid getting stopped out for the last two reasons. If we can eliminate obvious mistakes and understand why we are losing, then at least we’re losing intelligently.

This is already a big step ahead of many traders: especially those who don't know why they are losing in the first place. There are a few things you can do to avoid those unnecessary losses:

  1. Do not place your stop loss 1 pip below the most recent swing low, despite trading with the trend.

The market does not work off precise levels and exact prices. Levels can often be better thought of as “zones,” extending 10-20 pips around a given price point. Depending on the pair in question, and your broker, you’re already looking at a few pips of variance just in terms of spread.

Furthermore, it’s quite common for professional and retail traders alike to use swing highs/lows as logical places to place stops and/or reversal orders.

So, depending on the liquidity available in a given “zone”, the price can dip into the zone, find orders, and get rejected. In the case above, we would get stopped out of our trade, right where we should be looking for clues on continuation or rejection.

  1. Do not place your stop too close to the market

Liquidity is often found on either side of the Asian Range. As such, any trade taken in a range-bound situation should have a stop 15-20 pips outside the range barriers. This helps prevent being stopped out as a natural by-product of the market’s search for liquidity, or just pure volatility.

  1. Do not trade unless you have a logical and tested plan

This is possibly the worst mistake in the book. Attempting to trade without a sturdy plan in place will make you vulnerable. There are too many things the markets can throw at you. If you fail to prepare, prepare to fail.

Order Flow Intersections

We previously talked about liquidity pools as intersections of orders. Let’s now return to the point with some more context under our belt.

Common retail traders don’t usually have to think about liquidity. The market can easily absorb orders of up to $10m. This is far above the sizes they will trade, often even with high leverage.

Traders who trade above this size find liquidity to be a very real issue. They cannot think about the markets like common retail traders. Instead, they need to factor in where and how they are going to deploy their strategy. They need liquidity to deploy their bets without moving the market and without being detected. They also need to have a clear idea of where they will be able to exit, regardless of whether the trade ends up being successful or not.

Large traders (think big funds and Central Banks) cannot simply accumulate or distribute a large position whenever and wherever they wish. Instead, they must look for those places where liquidity is aggregating and stops are helping them in an indirect way.

Anybody looking to place a big order has a much safer opportunity to do so quietly. They don’t need to show their hands or influence the market too heavily. They don’t have to look or hope for liquidity if it’s already there.

Wherever stop-loss orders aggregate, there is a 2-way pool of liquidity being created. The traders that get “stopped out” are forced to issue opposite-side orders. They must thus give large traders the possibility to “fade” the stops that accumulate at those levels.

Since people are creatures of habit, they will usually use the same methods for deciding where to place their stops. For example, just below a recent low, or x pips away from market price. As we’ve discussed, those stop orders create liquidity because they issue a market order when they are triggered.

Major swing points on a major chart are the first place to look for liquidity. And they’re also the first places to keep an eye on what happens. Because, following the same logic, if large traders are active at these levels, then at these levels we have the first clues as to what the aggregate market knows and thinks.

  1. If an evident stop level gets broken (hurdled) and price continues in the same direction, that means the flow has become indigestible to the diverse participants and the price structure changes. This is usually driven by a significant event or strong fundamental reason.
  2. If an evident stop level gets faded, (a break, followed by a quick reversal) that means the flow is still in balance and it demonstrates that the fundamentals are still not strong enough to push forward.

 

 

Stop Being Exploited & Start Exploiting The Stops

Don’t get caught with the crowd. Understanding the dynamics of liquidity will help you protect your entries. It’ll also help you understand where on the price map the market is likely to make important decisions.

So, how do you do this?

  • Map evident swing levels created by the peak/trough action of the market
  • Observe the price as it approaches and vibrates the level
  • Keep in touch with the drivers behind the move
  • The market’s reaction will most likely tell you whether to fake or break

The key, as with many things in the market, is to keep it simple and subtle.

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