The goal of a financial market is to connect buyers and sellers in order to make trades happen. When the most amount of trade happens that is where trade is facilitated and the market has accomplished its purpose. Unfortunately for small traders, this means that larger traders (also called commercial traders and institutions) with bigger pockets are seeking to facilitate trade at the expense of the smaller traders. Liquidity hunting (also called stop hunting) is how this is accomplished. Remember this concept happens mostly on the more liquid markets where there are more traders such as currencies and futures markets.
In this article we will look into liquidity hunting and how it works. We will go over topics :
- Understanding liquidity hunting
- How institutions engage in liquidity hunting
- Strategies to avoid them
Let’s get right into it.
Understanding Liquidity Hunting
Liquidity hunting involves large market participants intentionally creating price movements to trigger stop loss orders placed by retail traders and smaller market participants.
The reason this is done is because large market participants need a lot of liquidity to execute large orders. If they were to place a sell order at the market price it would move the market so much that they would get filed at a very unfavorable price. However, by triggering a cascade of stop losses at market highs the institution would find the liquidity it needs for its position and be able to enter the market at a favorable price.
How institutions Hunt for Liquidity
Commercial traders deliberately hunt for liquidity by finding locations where there are a lot of stop orders. They will use obvious price points such as swing highs or key levels and force the market to go below these prices and force a liquidation of the stoplosses.
An example : say there is a nice level of support in the futures market that is forming and because the market is in an uptrend, many people will buy that support and look for a long trade. The next time the market comes to that level the big traders will short sell aggressively taking on a huge short position. This increased selling will force the market below support where all the retail stops are located. Currently the big traders are positioned short from the position they used to manipulate the market.
When the stops are cleared the big traders will use a separate account to buy a massive amount of future contracts. Since there is heavy buying the price of the market will move up after it is done clearing out the stops. From here the institution will be positioned long with a huge amount of contracts in one account but short with a big amount of contracts in another account.
Since they got their fill of their long trade idea all that is left is to bring the market back down to support to close the losing short position at breakeven. The institution begins selling the winning long position at a profit and this imbalance of selling causes the market to come back down. When the market is back at support the commercial traders will then close out the losing short position in the other account at a price close to breakeven. This way they were able to grab liquidity from a liquidity hunt, move the market in their direction, close the long position at a profit and then bring the market back to the entry to close the losing position at breakeven. They found their liquidity and were able to close the trade with a profit and not take a loss.
Strategies to avoid Stop hunting
Now that you understand how stop hunts work it is important to know what to look for to avoid them. The market will operate in sentiments (more information on this can be found here [link]). If the particular market being traded is a risk asset and the current sentiment is risk on, there is a good chance the market will do a stop hunt, accumulate a position for the large traders and then take off and pullback to close the losing segment of the position at breakeven. This sounds complicated but in reality the market hunting stops to find its liquidity and then takes off with the trend.
A good strategy of what to do is to look for obvious levels where other traders have placed their stops and wait for the market to stop hunting them. After the stop hunt you can wait for the mitigation and then enter the market in the correct direction of the trend.
Above is a sell example that happened on the on Crude OIL. A nice push up to run stops then heavy selling followed by a push up to close the long positions at breakeven before the continuation trend down move.
If you can spot this pattern on the correct sentiments under the right circumstances you can generate highly profitable trade ideas.
Summary
Understanding that liquidity hunting exists and it is commonly used by large commercial traders is the key to protecting yourself. With a proper understanding of manipulated price moves you can develop strategies to trade the market and avoid many stop hunts.
This will take time to learn and many instruments have their own specific intricacies so I would recommend to only focus on a few until you understand this concept very well.
Let me know if there are any other questions you have about stop hunts. Leave a comment and join our email list for more articles like this.
Happy trading, and as always trade safe!
Andrew Akl
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