Liquidity: The Fuel of the Market

This lesson explores the concept of liquidity, explaining what it is, where it accumulates on a chart, and why Smart Money actively seeks it.

What is Liquidity?

In the context of trading, liquidity refers to the ability to buy or sell an asset without causing a significant change in its price. On a practical level, it represents a high concentration of orders. For every buyer, there must be a seller, and vice versa. Liquidity is the pool of these pending orders that allows for transactions to occur smoothly.

Smart Money institutions, which need to execute enormous positions, cannot simply place a massive market order without drastically affecting the price to their own detriment. They require a large pool of opposing orders to fill their positions efficiently. Therefore, the market is in a constant search for liquidity.

Where is Liquidity Found?

Liquidity pools tend to form at obvious technical levels where retail traders place their orders. These are predictable areas of interest.

1. Swing Highs and Swing Lows:

   • Above a Swing High (Buy-side Liquidity): A significant number of orders accumulate above a clear swing high. These include:
     • Buy-stop orders from breakout traders looking to go long if the high is broken.
     • Stop-loss orders from traders who are shorting the market.
   • Below a Swing Low (Sell-side Liquidity): A pool of orders rests below a clear swing low. These include:
     • Sell-stop orders from breakout traders looking to go short if the low is broken.
     • Stop-loss orders from traders who are in long positions.

2. Equal Highs and Equal Lows (EQL/EQH):

   • When price forms two or more highs at roughly the same level, it creates a very obvious resistance level. This is a prime target for buy-side liquidity.
   • Similarly, two or more lows at the same level create a clear support level, a target for sell-side liquidity.

3. Trend Lines:

   • Liquidity also builds along well-defined trend lines, as traders place stops just beyond the trend line or look to trade breakouts from it.

4. Key Session Highs/Lows:

   • The high and low of previous trading sessions (e.g., previous day's high/low, Asian session high/low) are often targeted for liquidity.

The "Stop Hunt": Engineering Liquidity

A stop hunt (or liquidity grab/sweep) is a classic example of Smart Money engineering liquidity. Price will be deliberately pushed to a level where a high concentration of stop-losses is known to exist (e.g., just above a clear swing high).

1. The move triggers the stop-loss orders (which are market orders), providing the necessary liquidity for Smart Money to enter their large positions in the opposite direction.
2. Once the liquidity is taken, the market often reverses sharply, leaving breakout traders trapped and stopped-out traders on the sidelines.

This is why you often see price wick just above a high or below a low before reversing strongly.

Conclusion

Understanding liquidity is fundamental to SMC. It explains why price moves from one key structural point to another. Instead of viewing support and resistance as impenetrable barriers, view them as pools of liquidity that the market is drawn to. By identifying these zones, you can anticipate where the market might be headed next and avoid placing your stops in the most obvious locations.

In the next lesson, we will delve deeper into the specific tactic of Inducement.