Understanding Liquidity in Financial Markets

Jul 16, 2024

Understanding Liquidity in Financial Markets

Definition of Liquidity

  • Liquidity: Refers to how quickly and easily an asset, security, or market can be bought or sold without affecting the asset's price dramatically.

Price Action and Liquidity

  • Price Irrelevance to Time: Time frame doesn't matter when analyzing price in the context of liquidity.
  • Reference Points for Traders: Price action traders identify points in the market where there is a high probability of liquidity.

ICT Concepts on Liquidity

  • Buy Orders and Sell Orders: Understanding liquidity involves identifying where buy and sell orders are placed.
  • Swing Market Movements: Traders identify swings (e.g., market going lower) and understand that open profit positions may erode, leading to stops placed above significant highs or lows.

Liquidity and Market Movements

  • Buy and Sell Liquidity: Identifying areas where liquidity resides based on historical highs and lows.
  • Targeting Highs and Lows: Traders aim for areas where there has been significant movement targeting old highs for buy stops and old lows for sell stops.

Liquidity Zones

  • Open Float Concept: (To be covered later) Understanding the foundation that liquidity resides above old highs and below old lows.
  • Market Tendencies: Markets aim to target old highs and lows to knock out resting liquidity (buy stops or sell stops).
  • Price Action Analysis: Look at where orders are likely to reside rather than patterns.

Trading Strategies based on Liquidity

  • Low Resistance Liquidity Run (LRLR): Easier market movements through new or fewer levels of resistance. Favorable for trading.
  • High Resistance Liquidity Run (HRLR): Harder market movements with more resistance levels to overcome. Less favorable for trading.

Practical Examples

  • Examples of HRLR:

    • Market moving up through multiple resistance levels with difficulty.
    • Significant price action acting as resistance.
    • Requires significant events (e.g., non-farm payroll, FOMC announcements) to overcome resistance.
  • Examples of LRLR:

    • Market moving down with minimal resistance.
    • Easier for price to cut through low resistance zones.
    • Short-term highs or lows provide opportunistic trading zones.

Identifying Liquidity Zones in Price Action

  • Old Highs and Lows: Recognize them as points where liquidity is resting, and price may revisit.
  • Resistance and Support: Multiple rejections or supports at a level indicate strong resistance or support zones.

Institutional Order Flow

  • Institutions' Actions: Understanding how institutions defend or capitalize on price levels.
  • Market Makers: Use understanding of liquidity to make trading decisions that align with institutional moves.

Key Takeaways

  • Identifying High Resistance and Low Resistance Areas: Crucial for making informed trading decisions.
  • Focus on Liquidity Zones: Helps in predicting market movements.
  • Avoid Cluttered Zones: High resistance zones with significant price action are less favorable for trading.