If you've ever had your stop loss taken out by a wick of the price below a support, then you may have been the victim of stop loss hunting.
In this article I'm going to explain the broader concept of institutional order flow and give you some tips for how you can protect yourself and become a better trader.
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What is institutional order flow?
When retail traders enter a position, they can do so without issues.
When an institutional trader tries to, they run into problems with slippage and front-running. Their solution to these problems is to engineer liquidity.
Let's look at this in more detail.
Retail vs institutional traders
The key difference between the two trader types is the relative size of their trading accounts. Retail traders have relatively smaller accounts and institutional traders relatively larger ones.
These larger accounts can be really large personal accounts (whales) or trading firms/funds/desks for an institution.
The problem institutional traders face
When they want to enter the market, they only have two options. They can place a market order or a limit order.
Market orders fill at any price, but at the same time.
Limit orders fill at the same price, but at different times.
Let's say they place a market buy order.
Sitting on the order book are sell orders, waiting to sell for higher and higher prices.
When the large market buy order is placed, it blows through the order book as it tries to fill.
When all is said and done, the order will have filled, but at a much higher price than it should have. People notice the price is way up then jump in with their sell orders, restoring the balance of supply/demand, and bring the price back down to where it was before.
The result is that the institutional trader ended up paying way more than they should have. This is called slippage.
Alright, you say, well then why don't they just use a limit order? Sure it will take a while for it to fill, but at least they won't pay an absurd price.
The problem now becomes front-running.
They place their large limit buy order at the current price. It fills a small amount but pretty soon the price starts to increase, away from their order. What's happening?
Retail traders, coming to the exchange looking to buy, see the massive buy wall that has been created by the institutional trader's order.
"I don't want to wait for that huge thing to fill", they say, as they place their buy order just a tiny bit higher than it.
This keeps happening again and again until the asset starts to rally.
Remember that the institutional trader wanted to go long?
Well now they've just missed out on the trade because retail investors kept front-running them, preventing their order from filling.
To fix these problems, they had to get clever...
What is engineering liquidity?
Let's stick with our example and say that the institutional trader is trying to fill their buy order.
There are two different types of sell orders they can tap into.
- Stop losses (from long positions)
- Entries into short positions
The question is, where can they find lots of stop losses and people waiting to enter shorts?
The answer comes down to technical analysis.
Around key supports, retail traders will have their stop losses placed, knowing that a breach of the support will mean their strategy was invalidated. Similarly, traders looking to short will be waiting for a breach of support to buy the breakdown.
Engineering liquidity is the process institutional traders use to artificially push the price past a key support so that retail traders increase liquidity in the market by triggering their stop losses and opening short positions.
The liquidity that is available in these regions is called a liquidity pool.
How do we identify liquidity pools?
When you're doing your analysis, start by asking yourself the question, "where are retail traders' likely to place a stop loss?"
Higher time frames usually work better since more traders will be paying attention to moves on these scales.
1H and 1D tend to be the ones I look at. Occasionally 15M or 1W.
When there is a deep swing low or high, it stands out on the charts. This draws the attention of more retail traders to it as a key level.
Extended consolidation ranges
When an asset has been consolidating for a long time, the upper and lower bounds receive more attention, making them perfect places for liquidity pools.
Engineered long liquidity
Looking at the 1D chart of XRPUSD (Bitfinex), you will notice a few things.
- A sharp cut down to establish the lowest low, which clearly stands out on the chart
- A test of this low that just barely wicks out (twice)
Traders watching each of these moves would have been paying attention to these levels.
Those who had gone long would have their stop losses set at or just below it, in case XRP started to dump.
Those who were interested in shorting would have been waiting for it to breach the support so they could buy the breakdown.
If you look at the almost identical pair, XRPUSDT (Binance) you will notice the same wicking action doesn't happen.
One explanation is that there was one or two institutional traders looking to get in on XRP on Bitfinex and not on Binance.
Another example is from BTCUSD (Bitfinex), as shown below. You can see the support being breached briefly, without resulting in a breakdown.
Engineering short liquidity
Until now we've talked mainly about liquidity being engineered for long positions, but the opposite can also happen.
In this case, the price will be artificially pushed above a key resistance in order to encourage retail traders to open long positions and hit the stop losses of those with short positions.
Given that you can short fewer assets in crypto, it's much less common, but does happen occasionally.
What can you do to protect yourself?
Now that you know this is going on, how can you identify a genuine breakout from a stop loss hunt?
The honest answer is that you can't 100% of the time.
There are, however, some things you can do to mitigate the risk.
Avoid obvious liquidity pools
These areas stand out on the map. Usually as a sharp cut down to form a lower low on higher time frames.
If you can, simply don't place your stop there. Place it lower, ideally at another support a bit further down which doesn't stand out as an obvious liquidity pool.
Monitor the price action
If the move is a stop loss hunt, then price will often give you a reaction when it takes out the high/low.
This can look like a slow down in momentum, RSI divergence, or failure to close below on a high time frame.
Since it is an artificial movement, it won't respond in the same way a legitimate breakdown would.
Now that you're aware of this, you will begin to notice it on the graphs.
Keep track of which assets it happens to.
It happens much less frequently in crypto than in other markets, but when you do see it happen, it tends to happen again frequently.
Now that you understand institutional order flow, I hope that you can better understand why certain market movements happen. I hope you use this information to avoid, or at least reduce, how often you are stop loss hunted.
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Disclaimer: This is not financial advice. Invest at your own risk.