In the today's article, we will explore the concept of liquidity in Forex trading. We will go through an important theory, supply and demand, liquidity zones. I will share real market examples and useful trading tips for smart money concepts trading.
First, let's start with a definition of liquidity.
When the asset can easily and quickly bought or sold on the market, not affecting its price, we call such a market - liquid or the market with a high liquidity.
In contrast, low liquidity will signify that the asset may not be traded rapidly without significant price changes.
It happens because for placing any trade, you need to always find a counterpart:
if you want to sell, you need someone that will buy from you; and if you buy, you need someone who will be willing to sell.
High liquidity represents a situation when there is a constant flow of buying and selling orders, so that supply and demand remain in equilibrium.
Even the highly liquid markets don't have a constant, stable liquidity.
While some price levels will concentrate a high activity of the market participants, some levels can have a lack of interest.
The areas on a price chart, where the trading orders and the market activity concentrate, will be called liquidity zones.
Of course, we will discuss how to recognize these areas, but first, let's discuss why these zones are so important.
Liquidity zones are the magnets for the price.
When the market is trading beyond the liquidity zones, it can not keep the constant balance between buying and selling activity.
The excess of buying orders pushes the prices up to the closest liquidity zone, where the excess of demand will be absorbed by the sellers.
The surplus of selling orders will push the prices down to the closest liquidity zone, where the excess of supply will be absorbed by the buyers.
Take a look at a price action on GBPUSD. We can clearly see that there are some specific areas on a price chart, where the market finds equilibrium and the price start trading within a narrow range. While the excess of supply or demand, makes the market move rapidly, till one of such zones is reached, and the market finds harmony again.
For the institutional traders - the smart money, liquidity zones are crucially important for the smooth execution of their orders.
These market participants tend to trade with huge trading volumes. The liquidity zones provide the market depth for them - the availability of enough market orders to absorb the incoming market orders of smart money without significantly affecting the price of an asset.
How to identify liquidity zones?
The ability to recognize these zones is crucially important for Smart Money Concepts trader, because these zones may provide safe and profitable trading opportunities.
From this theoretical note, we may derive what constitutes a liquidity zone: the zone on a price chart where a huge amount of trading orders concentrate, the trading activity is high and supply and demand find the equilibrium.
One of the proven ways to identify the liquidity zones is no analyze a historic price action and find the areas on a price chart that were respected by the market in the past, the levels where the price was stuck for a substantial period of time or from where a significant bullish or bearish movement initiated.
Take a look at AUDUSD chart, I have underlined several important historical structures. All these areas, made the market stop growing/falling; their test initiated a consolidation or the reversal.
And of course, I will share with you the exact rules, how to underline these zones correctly, just keep reading.
Why the historic structures attract the liquidity?
The main reason is of course "the market memory". The fact that some particular price level made the market reverse or pause the movement in the past, will make traders and investors pay attention to such a level and place their orders accordingly, setting stop loss, take profit, buy or sell order around such a level.
Above we can see a strong bullish movement on EURCAD cause by the excess of demand.
The test of a historic structure - a liquidity zone, made the pair stop growing because the excess of demand was finally absorbed.
In order to draw liquidity zones properly, follow these 2 simple steps:
1. Identify the historically significant area that the price respected in the past
2. If the price is below the area, the upper boundary of that zone will be the highest wick within that area, the lower boundary will be the highest candle close within that area.
If the price is above that area,
the lower boundary of that zone will be the lowest wick within that area, the upper boundary will be the lowest candle close within that area.
Remember that you can identify liquidity zones on any market and any time frame. However, the rule is that higher is the time frame, more significant is the liquidity zone.
Practice and learn to recognize these areas because it is the foundation of smart money concepts.
