Market Mechanics: Liquidity Trading — A Comprehensive Guide
Liquidity Trading is one of several modules in my Market Mechanics series, and the concepts covered in this article are integral to becoming a successful trader.
You will absolutely become a better trader and develop a better intuition for market movements after studying this article, so pay close attention and be sure to keep this on hand for reference.
For those who can’t read, watch the shortened practical guide to Liquidity Trading below. It contains all the pertinent info and cuts out the extra stuff that you’ll want to study later.
If you’re looking for additional trading content or have any questions or comments, please come chat with me in my Discord channel.
Liquidity Basics
First, the elementary stuff. This is for new and beginner traders, so skip to the next section if you got this.
Every asset traded (a unit of stock, crypto, etc…) requires both a seller and a buyer, and the extent to which these market participants can agree on a price determines the degree to which the asset’s price changes with participation.
The ease/ability for market participants to enter or exit a market at a particular price is known as liquidity.
Example:
If you’ve been given $100 to buy 25 bottles of soda for a party, and the grocery store is stocked full of soda for $3 each, you can get your soda no problem. This is high liquidity.
But if there are only 5 bottles remaining at the grocery store, and the vending machine has the rest of the soda for $5 each, you have a problem. This is low liquidity.
Real Illiquid Markets
Pax Gold ($PAXG) is a gold-backed cryptocurrency that is highly illiquid. Below you can see the price at which $PAXG is being traded (middle), while the buyside and sell side orders placed are listed in the blue and red columns, respectively.
The current market price is the particular price at which traders last agreed on price and completed a trade, which in this case it is $1752. But as you can see, there is a very small number of assets available on both the buy side and the sell side.
So for example, if you wanted to buy 40 PAXG assets at market price, your average buy price would be $1765.4 and not $1752 (you do the math), because the only willing participants on the sell side have their units for sale at $1764 and above. Note: this is called slippage.
Now imagine a trader wants to buy $1M of assets in a highly illiquid market…
The $AXS Case Study
A thief gained unauthorized access to a Binance user’s API key and used it to place a $1,000,000 market buy for $AXS on behalf of the victim.
The price shot up ~200% because there was not enough liquidity to enter this market with that much capital.
Most likely the thief was waiting on the sell side with their own account so they could exit their own underwater position using the victim’s liquidity.
Market Movers Need Liquidity
This brings us to the most critical point in the article: Market Movers need extremely liquid markets.
What is a Market Mover? They are market participants that have so much capital that they are capable of moving markets. To put it another way, they run the show. Think trading firms, hedge funds, exchanges, and billionaire independent traders.
Most retail traders (you) believe the markets are manipulated by these Market movers, and rightfully so… they are. But Market Movers are bound by a restriction that retail traders don’t generally have:
Market Movers can only [meaningfully] participate in the market when there is very high liquidity, and oftentimes can only enter/exit if they break their trades up into smaller pieces over a larger period of time to avoid massive slippage.
The Retail Trader Advantage
A retail trader is anyone who is trading their own money rather than trading for an institution.
As long as retail traders can identify areas with high liquidity, they can predict with a higher probability where Market Movers plan to participate in the market.
And although Market Movers try to hide their presence as not to be front run or countertraded, they inevitably leave behind signs of active market participation.
With this knowledge, retail traders can determine when and where Market Movers are likely to participate, and can monitor those areas for signs of activity. This allows retail to trade alongside institutions rather than becoming their liquidity.
Types of Liquidity
Before getting into charts, it’s useful to understand the differences between the three main types of liquidity: market liquidity, order book liquidity, and transaction liquidity. Each of these refers to a different aspect of how easily and quickly it is to participate in a market.
Order book liquidity refers to the liquidity that is available at a specific price point in the market, and it is typically measured by the size of the orders that are placed at that price point.
Think about the $PAXG example. The amount of units on the buyside and the sell side at their respective prices is the order book liquidity.
Market liquidity refers to activity in the market, and it is typically measured by metrics such as the number of assets traded, the volume of trades, and the amount of capital invested in the market.
Take large market cap cryptocurrencies like Bitcoin for example, which are known for high trading activity. These markets are considered to have high market liquidity due to the size and high trading activity.
Transaction liquidity refers to the liquidity that is available to a specific trader at a specific time, and it is typically measured by the size of the orders that a trader is able to execute at that time.
The $AXS case study is a perfect demonstration of this. The victim’s account experienced low transaction liquidity while the thief was likely offloading $AXS from their own account in what would be considered high transaction liquidity.
Identifying High Liquidity Areas
While there are many methods for identifying high liquidity areas in the charts, the ones I describe below are the most effective in my experience and are much more difficult to manipulate.
Price Action Artifacts
This section will examine the generation of liquidity through Trending Price Action, Ranging Price Action, and Contracting Price Action.
Trending price action generates liquidity through the formation of a series of higher lows and higher highs (uptrend) or lower lows and lower highs (downtrend).
When market participants enter at each low or high, they typically place their stop losses just below or above the level of their entry. This creates a cascade of liquidations or stop losses in the opposite direction, which generates liquidity for large traders who can then enter or exit their positions at a favorable price.
Below is a depiction of upward trending price action which generates liquidity to the downside. This type of liquidity is an example of Order Book Liquidity.
At this point, a Market Mover has two reasons to push price downward toward those stop losses. Either they have already filled their short positions, or they intend to enter a very large long position, or both.
Ultimately the reasoning or intentions behind market structure doesn’t matter in this context. All that matters is where the liquidity is at.
When price moves downward and begins hitting stop losses (see image below), traders still in their long trades are forced to sell their positions and possibly liquidate their accounts. This is equivalent to opening new positions in the opposite direction, so in this case it would be as if new shorts were opening.
This creates massive sell pressure as each long is forced to sell at whatever price they can get. But because most of the buyside market participants are currently being forced to sell, there aren’t many buy orders below to absorb the cascade of sell pressure (think back to the highly illiquid $PAXG order book or the $AXS pump).
This results in a very quick move to the downside and generates enough liquidity (via desperate sellers) for interested Market Movers to fill their longs and flip their shorts if they so desire.
Ranging price action generates liquidity to both the upside and the downside in similar fashion to trending price action, but without the cascade. Longs are placing their stop losses below the range and shorts are placing their stop losses above the range.
When stop losses at the top are triggered (equivalent to new longs entering), larger traders suddenly had enough liquidity to fill their short positions. Conversely, the opposite is true for stop losses at the bottom of the range.
In the image below, price moved up to take topside liquidity. Notice that a series of higher lows was formed inside the range as price was moving upwards. This resulted in a very quick move to the downside after triggering the stop losses at the high side.
Contracting price action can trend upwards, downwards, or move sideways like a range. Upward and downward contracting price action generates liquidity in the same way as uptrends and downtrends.
Sideways contracting price action generates liquidity to both the upside and to the downside, but generally results in a much more volatile and unpredictable breakout than a range due to the cascade of stop losses on both sides (image below).
Oftentimes, price will whipsaw both to the upside and to the downside taking out all traders in the area like shown below.
When bringing all of these sections together (below), you can see why it’s so critical to understand how to identify liquidity in the charts. Liquidity is fundamental to how markets operate and trading without it is like trading blind.
High Volume Nodes
High Volume Nodes (HVN) are areas in the chart where there has been a relatively large volume of assets traded in the past and is an example of Transaction Liquidity.
These areas act as magnets for price because this is where market participants have historically been most active, and price tends to revisit these areas.
In particular, this is where Market Makers have injected the most liquidity to fulfill the demand for orders on both sides of the market, thus reducing the spread and slippage for traders.
Consequently, large traders are incentivized to participate in the market at these areas.
One common tool used to identify HVNs is the Volume Range Profile. In the image below, a Fixed Range Volume Profile tool is pulled from the top of the downtrend to the current bottom of the downtrend to reveal two clearly defined HVNs.
Note that market participant roles and the strategies and tactics used by institutional traders, as well as more in-depth volume concepts are topics that will be covered in a different module.
When price action forms a trend or range in such a way that liquidity is generated in an area of historically high volume, Market Movers have the opportunity to participate at a significantly reduced cost.
In the image below, price action did exactly that — formed two swings to the high side and two swings to the low side, with a HVN just above the upside moves.
Subsequently, price moved upwards and triggered the stop losses that short traders placed in the HVN.
Heatmaps & Liquidation Software
Heatmaps are a popular tool traders use to identify where stop losses and liquidations exist in the order books. The depiction below is a heatmap by TradingLite.
While this can be useful for stop losses, limit orders, and liquidations that are placed beforehand, it will not show the invalidation levels (soft stop loss) of Market Movers because they typically do not use a hard stop loss, opting rather to monitor price and execute a market order in the moment that their invalidation is hit.
The same goes for limit buy orders placed in the books beforehand. Market Movers do not want to advertise their presence, and if they do they have a reason for it. So generally they will monitor price and execute at market when conditions are favorable, or place a limit order the moment before price hits their entry.
As for large liquidations, large traders with conviction may defend their position and add margin when required, rendering the liquidation level invalid.
Additionally, Market Movers commonly manipulate heatmaps by purposefully advertising their presence with large orders in the books, whether it be stop losses, liquidations, or buy orders.
With time and experience and when used alongside Price Action Artifacts and High Volume Nodes, liquidity maps can be a powerful tool as long as traders are aware of Market Mover strategies.
Factors Affecting Liquidity
It is important to understand factors affecting liquidity because it can influence the way both retail traders and Market Movers participate in the market, and the success of some strategies really depend on these factors.
Market Conditions
Economic and political events can affect liquidity in financial markets, as can changes in interest rates and other macroeconomic factors. For example, when central banks raise interest rates, it typically makes borrowing more expensive, which can have a dampening effect on economic activity.
As a result, traders may be less willing to take on new positions or to hold onto existing positions for long periods of time, leading to reduced market liquidity. To capitalize on opportunities in a more volatile market, traders must understand how market participants respond to these conditions and adjust their strategies accordingly.
News & Events
Many traders begin their journey attempting to trade based off of news and events, quickly realizing that this approach is inconsistent and counter-intuitive, and can lead to catastrophic losses.
News events can have a major impact on liquidity, but it is important to have identified liquidity areas in the charts beforehand because regardless of the news, price will still react based on the fundamental concepts of how financial markets operate (i.e., liquidity) — not the goodness or badness of the news.
For example, on February 24, 2022 news outlets and social media became flooded with the news that Russia launched a major military invasion of Ukraine. The resulting conflict and geopolitical consequences of this invasion were, and still are, detrimental to the overall global economy.
The news was so bad that even advanced traders were overtaken by fear and FOMO’d into shorts. And for most of the day it seemed like the right trade (image below).
But prices aren’t determined by news — they’re determined by the interaction between market participants which is based on the fundamental aspects by which markets operate.
While everyone was FOMO selling/shorting based on the badness of the news, Market Movers who truly understand markets were trading based on the volatility and liquidity generated by the news.
In the image below, price quickly drops into a pool of order book liquidity, wicks through a 0.886 Fibonacci Retracement, and quickly reverses to the upside. Over the course of the next 30 days, price appreciates 40% before reversing to the downside.
Note that Fibonacci Retracements and other technical analysis tools & methods will be covered in a different series.
Off-Chart/Dark Liquidity
The volume and type of trading activity is a crucial factor in understanding when and where liquidity is entering the market. It’s clear that liquidity is correlated with trading activity, although there are exceptions such as high-volume low liquidity conditions. However, what many traders don’t realize is that liquidity and volume can also be influenced by off-the-books trades and investments.
For example, in financial and cryptocurrency markets, institutions may make large purchases directly from the source instead of going through an exchange. This allows them to avoid the potential issues that could arise from buying through an exchange. In a cryptocurrency bear market, we can see this activity when exchanges, miners, and startups begin to fail. Profitable and solvent institutions can then acquire assets from these insolvent entities through private deals.
While these off-the-books trades may not be visible on the charts, they can have a significant impact on liquidity and price movements. Understanding advanced market mechanics like these can give traders and investors an advantage in long-term trades, but in the short term, price movements may be more influenced by volatility and liquidity generated by news of institutional insolvencies.
Time-based Liquidity
Identifying time-based liquidity patterns is an understated skill for traders. In traditional centralized markets, it is relatively straightforward for retail traders to understand the trading hours and holidays. Markets typically open at the beginning of the day and close at the end of the day, as well as on weekends and holidays. By understanding the regular trading schedule, traders can plan their trades and manage their risk accordingly.
Beyond regular market closures, liquidity is affected by time-based factors such as the session, time of day, week, or season. Different assets and asset classes may exhibit their own patterns of time-based liquidity, and it can be difficult to identify the underlying causes of these patterns. However, it is important for traders to recognize these patterns and adapt to changing liquidity conditions.
In decentralized markets which never close, it can be easier to recognize time-based liquidity patterns. For example, liquidity for Bitcoin trading is generally thin during the weekends and is often accompanied by less predictable volatility and relatively low volume moves that don’t justify the size of price movements.
This can make it challenging for traders to enter and exit positions with precision, and can also increase slippage. However, with experience and careful analysis, these lower liquidity conditions are opportunities to develop a trading edge.
If you’ve made it to the end of this series, congratulations. Studying the liquidity content synthesized here is truly a necessary part of becoming a successful trader.
If you want more advanced trading content or have any questions or comments, please come chat with me in my Discord channel!
