Transcription
There are two challenges that traders typically face with liquidity. The first is knowing which level is actually being targeted, and the second is knowing whether the price is going to make a continuation or a reversal. This involves an understanding in advanced market structure, which most traders lack.
So, in this video, we've broken down everything you need to know about trading liquidity into five simple steps. So let's waste no time and start with step number one, which is understanding the different forms of liquidity. Liquidity refers to areas in the chart that either contain a large, large quantity of unfilled orders or a large quantity of stop losses, and it presents itself in two different forms.
When people typically talk about liquidity, they are usually referring to the external range liquidity, which can be either a previous swing high or a previous swing low. These are pivotal moments in the chart because they either result in a trend continuation or a trend reversal in the form of liquidity runs and liquidity sweeps, which we will be covering further into the video.
The other form of liquidity is internal range liquidity, which is just another for fair value gaps. This is what the price uses as fuel to attack the swing highs and lows. It's important that you pay attention to how the price interacts with both forms of liquidity because together they will tell you which direction the market is going to move.
For our next step, we need to talk about order flow and how it can help us determine which liquidity level we should be targeting. When we look at a chart, the first thing we should do is look to see whether the current order flow is bullish or bearish. This depends on whether the price is pushing through buy-side or sell-side liquidity, which can can seem confusing at a glance. But we can simplify this through the use of two concepts, which are called break of structure and change of character.
So let's see how they work. When a new swing forms on the chart, liquidity levels are created at the swing high and swing low. The liquidity level at the high is called the buy-side liquidity, and the liquidity level at the low is called the sell-side liquidity. For the context of break of structure and change of character, we look at which type of liquidity was ran through when this new swing was created, which in this case was a buy-side liquidity. This means we are currently in a bullish order flow.
So, with this in mind, our current break of structure level is the buy-side liquidity. This is because a break of structure refers to the level that would need to be broken through in order for the current market trend to continue, which in this case is an uptrend. And on the other hand, the current change of character level would be the sell-side liquidity, and this is because if this lower level was to be hit, it signals to us that the order flow might be looking to change, which in this case would be from a bullish order flow to a bearish order flow.
But in this instance, the price pushes up and through the buy-side liquidity, which creates the break of structure, confirming that the uptrend is continuing. And now, with this new bullish swing, we have a new set of break of structure and change of character levels that we can use to assess if this uptrend will continue to progress.
Here we have another depiction of a price swing, but this time when we look at the liquidity that was broken before this swing was created, we can see it was a sell-side liquidity. This means that this chart would currently be in a bearish order flow, and this means that the current break of structure would instead be the sell-side liquidity level because this would be the target level if sellers wish to continue the downtrend. And on the other side, the change of character level would be the buy-side liquidity because this would signal a change in order flow from bearish to bullish.
But for this example, the price chooses to push down and through the sell-side liquidity, confirming the break of structure, which tells us the current downtrend is continuing. So, in summary, a break of structure refers to when a liquidity level is run that confirms the continuation of the current trend. And what one of the most important rules in trading is that we should always trade the direction of the market's order flow and not against it.
But this leaves the question: how do we know when the order flow has reversed? Well, here we have another uptrend validated by the break of structure. Let's say price has hit resistance here, but this time, instead of creating a higher low, we instead see price push down to form a lower low. This is what we call a change of character because it is the first signal that the price action may be changing from bullish to bearish.
When this occurs, this lower low becomes the new break of structure, and the previous swing high now becomes the change of character level. This is because this high is now the level that would have to break in order to signal that we could be returning back to bullish order flow. But as it stands, we shouldn't flip our bias to bearish just yet. And the reason being is that this change of character could really just be a liquidity sweep.
Instead, we want to wait to see if the price will push down and pass the break of structure level, as this will confirm the start of a downtrend. So, in summary, a break of structure confirms a trend continuation, and a change of character signals that the direction of the order flow could be reversing.
We'll now develop what we've covered so far in our next step, which is understanding the relationship between external and internal range liquidity. Here we have an uptrend, and we know this because the price has created a break of structure by pushing through the previous swing high. And with this new bullish swing that was created, we have our current external range liquidity levels.
But because we know this structure is currently in an uptrend, we should be expecting the price to target the upper buy-side liquidity level. But in order to do this, it needs to find some kind of support that can create the next bullish leg. And this is where we look within the previous swing for bullish internal range liquidity in the form of a bullish fair value gap. And this is what the market can use as fuel to go and push through the buy-side external range liquidity.
So, what we've just seen happen is the market has used internal range liquidity to push through the external range liquidity level, and this has now given us a new swing with its own external range liquidity levels. And if we are expecting the price to continue this uptrend, we should again look within this new swing to find a bullish fair value gap that can be used as fuel to create the next leg up.
So, to summarize this, during an uptrend, we expect to see the impulsive moves leave behind internal range liquidity in the form of bullish fair value gaps that can then be used in the future to push through the buy-side external range liquidity to create new higher highs. And for downtrends, it's the same but just in reverse. If we are expecting price to break through the sell-side external range liquidity levels, we want to look within the previous impulsive bearish move for internal range liquidity that can progress the move lower in the form of a bearish fair value gap.
So this explains the relationship between internal and external range liquidity, which is how the trending moves are formed on the chart. And it's important to always keep this in mind when doing your technical analysis because when we see the internal range liquidity get disrespected, it's the first sign that the market is wanting to attack the change of character level, which could result in a full reversal.
So now it's time for the next step, which involves understanding the difference between liquidity runs and liquidity sweeps, and more importantly, how we can predict which of the two is going to happen. When the price attacks an external range liquidity level, which is either a previous swing high or a previous swing low, it can do one of two things. The first option is for it to continue in the same direction, which is what we call a liquidity run. And the second option is to create a reversal, which is what we call a liquidity sweep.
This might seem simple at a first glance, but understanding what price is going to do at a liquidity level is where most traders struggle. So let's start by looking at liquidity runs first. Here we have a swing high, which is the current external range liquidity that we are drawing into. Price then pushes up and closes above the level, but as it stands, this isn't yet a liquidity run. It has only created a breakout.
What we are looking for is an additional bullish candle to form that creates a bullish fair value gap that overlaps with the breakout of the external range liquidity. This is because in order for the bullish move to continue, it needs to create internal range liquidity, which it can use as support during the next retracement. On the other hand, if it were to create the fair value gap above the level, this is also valid. The important part is that the internal range liquidity is created during or after the breakout because this shows strength for the buyers by creating an area that they can use as support for the next leg up.
However, if the fair value gap was created before the breakout, we cannot use it for validation of a run on liquidity. We have to wait and see if the chart creates the correct internal range liquidity that favors a trend continuation. As for liquidity runs on the sell-side, we use the exact same principles, just upside down. This means we are looking for the creation of a fair value gap either within the breakout of the liquidity level or underneath it. We don't want to consider the fair value gaps that formed above the level.
So let's now talk about liquidity sweeps. Here we have another swing high as our draw on liquidity, but this time when price attacks the level, it fails to push over and close above it. This shows massive weakness in the buyer efforts, creating what many know as a fake out, which is the clearest signal we could get that the price is creating a liquidity sweep. From here, we expect to see a reversal in order flow, meaning we should now be looking for short entries.
But in the instance that this bullish candle does close over the liquidity level, it doesn't mean a liquidity sweep is off the table. And this is because if we look at where the last bullish fair value gap was created, we can see that it's below the external range liquidity. So if price was to move down from here, there's a high chance that this fair value gap will be completely disrespected, which is the first signal that the order flow could be switching.
But with that said, we don't want to consider shorting just yet. Using the knowledge on market structure that we covered earlier in the video, we want to see if the price will push down below this previous swing low because this would create a change of character, which is the second signal for the change of order flow. But the final piece that we are looking for is whether this bearish leg down managed to create a bearish fair value gap because this is what sellers can use as resistance to continue the downward move, creating a new break of structure, which confirms that the market has now transitioned into a bearish order flow.
This is the typical setup that we tend to see when the market creates a liquidity sweep. And the important note to take here is that we shouldn't actually be taking trades solely on how the price reacts to the external range liquidity. Instead, we should be looking at how the market structure forms and then look for entries when it has shown a clear directional bias, which moves us on to the next step, which is that we should be using top-down analysis when looking for our trade setups.
We'll demonstrate this by analyzing this segment of a chart on the 4-hour time frame. So firstly, we want to know which direction the current order flow is moving in, which we can see is bullish because we have this break of structure through the previous buy-side liquidity. So this means we should be looking to buy from somewhere within this range. But where exactly should we be looking for our trade entry?
Well, going back to what we covered earlier about the relationship between external and internal range liquidity, we should be looking for a fair value gap within this leg that we can use for our long trade. But even with this, we shouldn't just blindly take a trade if the price draws into it. What we should instead do is move down into a smaller time frame to analyze whether the market actually respects this 4-hour fair value gap.
So here we are looking at the same chart, but now on the 15-minute time frame, and as expected, we can see the current order flow on this time frame is bearish, which we can confirm with this break of structure. But remember, we want to enter a long trade, so what we are looking for is a reversal on this 15-minute time frame so it aligns with the bullish 4-hour order flow.
And when we mark out the current external range levels, we see a sweep occur, which, as we know, is the first phase of the reversal we are looking for. We then see the bearish fair value gap get disrespected, followed by a change of character, which means all we are waiting for now is the bullish break of structure to signal the reversal is complete, which it doesn't take long to do. When a reversal like this occurs, the first fair value gap to form afterwards is what is commonly known as the Silver Bullet.
This is because it is the highest probability fair value gap that the market can offer. So this is what we will use to enter our long trade. And now we can switch back to the 4-hour time frame with the confidence that this 4-hour fair value gap has been respected based on the confirmation of the 15-minute trend reversal. And from here, we want to see the price push up to the buy-side liquidity where we can exit our trade.
We could, of course, hold this trade for a longer period if we believe the market will continue in the bullish direction, but if we were to do this, we need to move up to a larger time frame so we can analyze the larger market structure. And now, here on the weekly time frame, we can see that the market is actually making very bearish swings, which means whilst our short-term trade made sense on the 4-hour time frame, the price has actually moved into a weekly bearish fair value gap.
So we should be expecting a reversal on the lower time frames to align with the weekly market structure. The key takeaway here is that we should always analyze what the market is doing on the largest time frames first because this will give us an idea of how we can expect the price to behave when it hits an area of liquidity on the lower time frames. If you found this video helpful, please leave a like and then comment what trading concept you'd like to see us cover next.