As retail traders, we have the luxury of entering and exiting any position with ease - the size of our trades are not large enough to affect the market whatsoever.
Now put yourself in the shoes of a bank, a multi-billion dollar fund - any type of institutional trader. You want to go long $2 billion dollars on a stock, a forex pair, a cryptocurrency - in doing so you face some issues.
So what are you to do? Take advantage of liquidity pools!
Here's the premise:
As an institutional trader, what do you need in order to go long?
Many peoples selling short.
What do you need in order to go short?
Trapped buyers.
So this brings us to the next question - How do institutions create sellers if they want to go long, how do they create buyers if they want to go short?
Liquidity Pools
Liquidity pools are areas where we can assume clusters of limit orders and/or stops reside.
Pending limit orders are, by definition - liquidity! They are triggered as price trades through a particular area.
From an institutional perspective - if price trades through X:
This brings us to the next question: How do institutions identify liquidity pools?
The answer: Where does the average retail trader place their stop?
Above highs, retail traders wait to buy the breakout. They create short liquidity by buying from institutions who are selling short, with the intention of taking the price lower.
Retail traders who short tops tend to place stops right above them - their buy stops create short liquidity as well if price is to wick through a high before going lower.
Trading breakouts, breakdowns and ranges from this perspective gives much more context to "fake breakouts" as they were - the key takeaway is to avoid placing your stops in obvious areas - as these regions tend to get hunted for liquidity.
-Will, OptionsSwing Analyst
Now put yourself in the shoes of a bank, a multi-billion dollar fund - any type of institutional trader. You want to go long $2 billion dollars on a stock, a forex pair, a cryptocurrency - in doing so you face some issues.
- You're trading massive size. These types of orders are nearly impossible to hide - people reading the tape, watching level 2 or the DOM (Depth of market, footprint, etc) will see your order from a mile away and front-run you so they can get in on the coming volatility.
- Remember - for every buyer (you) there needs to be a seller. How can you ensure you can receive $2bil in shares at the price you're looking for? Who's providing that liquidity?
- Following up on point 1 - you can't just buy, buy, buy 100 lots at a time until you get the quantity you desire - price will have moved substantially by the time you're done.
So what are you to do? Take advantage of liquidity pools!
Here's the premise:
- Short selling provides long liquidity - they sell the stock anticipating price will go down.
- Longs provide short liquidity - they buy the stock anticipating price will go up.
As an institutional trader, what do you need in order to go long?
Many peoples selling short.
What do you need in order to go short?
Trapped buyers.
So this brings us to the next question - How do institutions create sellers if they want to go long, how do they create buyers if they want to go short?
Liquidity Pools
Liquidity pools are areas where we can assume clusters of limit orders and/or stops reside.
Pending limit orders are, by definition - liquidity! They are triggered as price trades through a particular area.
From an institutional perspective - if price trades through X:
- Buy orders hit the market = potential short liquidity.
- Sell orders hit the market = potential long liquidity.
This brings us to the next question: How do institutions identify liquidity pools?
The answer: Where does the average retail trader place their stop?
- Below a swing low or a range low (think flags, channels, trends)
- Above a swing high or a range high (think flags, channels, trends)
Above highs, retail traders wait to buy the breakout. They create short liquidity by buying from institutions who are selling short, with the intention of taking the price lower.
Retail traders who short tops tend to place stops right above them - their buy stops create short liquidity as well if price is to wick through a high before going lower.
Trading breakouts, breakdowns and ranges from this perspective gives much more context to "fake breakouts" as they were - the key takeaway is to avoid placing your stops in obvious areas - as these regions tend to get hunted for liquidity.
-Will, OptionsSwing Analyst