This week we have an article from our trader Stephen where he explains the concept of "stop-hunting". The thesis of how large institutions see retail traders' orders as their liquidity provides an interesting and unique perspective to see a market. Enjoy this great article!
Ever wonder why your stop gets tagged when trading? Even though you place it in a spot where "For sure this time, there is no way price will want to come to my stop level"
As a trader, especially a new trader – I have always wondered why my stops were getting tagged only for the price to briefly run that area that I ever so diligently researched…hit my stop level…..then continue on in the direction of my original analysis and run to the level where my take profit would have been. All while leaving me behind wondering……what in the hell did it do that for???? This is obviously a common problem that has plagued most traders. At least I know I battled with this very issue for years.
What I came to realize was that there was a very distinguishable pattern that was occurring and it was repeating itself over and over again. I noticed that the traditional theory of supply and demand, areas of support and resistance or trading patterns of double tops / double bottoms which I was taught time and time again that price always defended these areas, was actually not a real thing. I started to do some research on this phenomena and after looking down several dead ends and roads that went on forever with no end in sight, I stumbled across a few ideas that started to make some sense.
The theory was….. Put me into the shoes of the large institutional banks vs. every day at the home trading warrior who was going to dominate the markets. If you were a big entity with a never-ending supply of money and you wanted to get a huge chunk of it into play, you can't just dump the whole lot into the game and expect all your orders to be filled at once, then have price take off in your intended direction….no….. it doesn't quite work that way.
What these large entities need to do is pair up orders.
And they do that order matching by sending the markets to areas where there is lots of liquidity …. AKA your stops!
Let's say for example you analyze the markets and determine that price wants to run higher to an old daily objective as it is currently in a bullish uptrend. And for the past day or so you see price not willing to go any lower. What looks to be a bit of a price shelf or support level where the price is all in a nice tight consolidated row that just doesn't seem to want to go lower and you know for sure this time price won't go below that heavily defended area…..only for the price to quickly run down and reject to go higher (in this case a long position).
And I started to notice that these "safety zones" or areas where price definitely won't come up / or down to are actually used by these large institutions as feeding grounds to capture liquidity and add more positions for them to get involved in a larger movement with.
They need lots of money to buy into and your sell stop is just perfect to do this. Most traders place their stops a few pips/ticks/cents below these tight pack range of candles thinking that they are safe as price clearly doesn't want to come down below them. And the majority of traders have their positions liquidated by the big capital hungry banks to feed the overall move higher than you were originally correct about.
So the million-dollar question is how do you avoid this pitfall from happening to you? There are a few ways to manage this and prevent your hard-earned money that you have at risk in the markets from being taken away from you in an instant.
I noticed that if you look at these areas (in the above example a long position) as an opportunity rather than a safe zone to place your stop you will do much better in your trading career. What I mean by that is, anticipate them coming down under those equal lows and instead of getting long above the consolidation area, try getting long below it. Yes, this means you'll have to go long when the market is running against you and I know, I know, it feels very awkward and wrong and goes against everything you've been taught…but trust me this method gets you the absolute best entries possible.
Imagine: getting in on the low of the day and riding price action all the way to the top of the daily range!!! Wouldn't that be amazing?
Well if your forecasting skills are on point and your market analysis is telling you to go long, then all you need to do is wait for the perfect entry. Let the price build-up and create this "shelf's in price" or support areas.
Let the market move sideways and bounce around like a pinball teasing all the other traders who got long at the tops of these things and placed their stops just below them in hopes that price won't want to come down and stop them out. All the while playing with their emotions and keeping them on that cliff of – is this going to be a winner or a loser of a trade? Then when price does the unthinkable and runs lower than that support area and scoops up all the traders stops you can then go long and partake in the glorious upside of being right – and obviously make some money doing it.
Sound easy? Well, it's not. It takes patience and timing and knowing when the markets usually send price south of the border to grab all those willing participants who hold their stops on a silver platter for the fat and hungry banks to gobble them up.
You need to identify times of the day when they make the false move apparent. Or when they make that low of the day – typically this happens within the 1st 1 – 4 hours of the trading day and I don't mean when the banks come online at 8 am NY time either. I mean at the start of the day 12 am.
So yes you will probably need to be awake if you like to watch price do its thing and don't quite trust the process of buying into those down candles.
Or like me, use a limit order – then go to sleep and trust your overall analysis to be correct and wake up with a nice little start to your morning.
But the trick is – where do you buy under the lows?
And when you do buy, where does your stop then go?
These are all great questions that I could try to specifically define here – but unfortunately, all markets are different.
But as a general rule of thumb:
1. You can anticipate these stop sweeps to happen in grades of 5's and 10's. Typically the average is about 10, cents, pips, ticks or otherwise. The larger the move down the more likely that it is not a stop raid and likely a trend reversal. So you can eliminate too much risk and keep your stop relatively tight.
2. Your stop will need to go below the next swing low on the 1hr chart. At a minimum, and yes that could mean a larger risk profile that you usually are willing to take. But if that's the case try dialling back your leverage. You don't need to make a million dollars every trade. It's about consistency not winning the lottery when trading.
3. You need to be confident in your analysis that price will move higher because the overall trend directions point it that way. I do not recommend trading against the trend on these types of trades. You need to be fully in alignment with the overall daily price direction. And trade into it.
Also, a great way to place your take profit for maximum reward to risk ratio:
Try placing it in areas above the market where short-sellers would be placing their stops 🙂
So in a nutshell, all the information I mentioned above can be readily found with a bit of research, I didn't come up with it on my own and these concepts are not new. But how you apply them to your personal trading style is all up to you and your success and/or failure depends on your understanding of these concepts. Price is fractal and will want to come back to areas that it has previously traded before – if you understand that simple fact you should do very well in your trading career.
Thanks for reading, I hope this has at least opened you up to something new that might help you down the road.