Understanding order flow and market depth is essential to seize opportunities in a bull market.
Editor’s note: The main explanation of this article is that market trading is not entirely controlled by 'smart money' as some popular trading theories suggest, but rather based on the interaction of market depth and order flow. Large traders execute orders by choosing areas with sufficient liquidity to avoid additional trading costs. Traders should focus on the actual structure of the market and the movements of participants, rather than overly mystifying market operations.
The following is the original content (for ease of reading, the original content has been reorganized):
If you have been in the trading circle for a while, you may have noticed that there is always a 'strategy of the month,' in other words, the trading system that is widely discussed by everyone. Besides the countless private messages I receive on Twitter asking about the smart money concept, you can see these 'SMC' traders popping up on major platforms.
Social media platforms like Instagram, YouTube, and Twitter are full of retrospective TradingView charts showing trades on a 1-minute timeframe with returns of 10-20R (risk-reward ratios). I am writing this article to reveal some of the real reasons behind market movements, why markets fluctuate, because I am so tired of hearing claims about 'market makers manipulating the market.'
Strategy Concept
First, what is the concept of smart money?
SMC trading is a derivative form that stems from the teachings of inner circle traders (ICT); simply put, his trading approach is based on smart money continuously manipulating prices to trigger retail traders' stop-losses and create liquidity in the market.
ICT refers to these individuals as 'market makers,' a term I will mention later.
These concepts have become very popular mainly because they are 'cool.'
New traders around the world sit at home, losing money on MetaTrader 4, seeing terms like 'smart money' and 'manipulation,' suddenly feeling like they are no longer retail traders. They now fully understand how financial markets operate because they can see the 'behind the scenes' of those hidden operations happening every day.
But the fact is that the 'ICT concepts' do work, but the reasons why they work are far more boring than they may seem on the surface.
One very popular thing that ICT and SMC traders do is rename and complicate things to make them sound more attractive, making you feel like you now possess insider information that others do not know.
If you go watch this video by Chris Lori, which is over ten years old, Chris Lori is one of the students of ICT, you might understand the origins of these concepts.
Over the years, these concepts have expanded to other markets, such as cryptocurrencies, and still heavily rely on the notions of 'manipulation' and 'market makers.' I leave it to you to judge; just ask yourself one question: who do you think sits in a bank all day staring at a 1-minute USD/CHF chart or some cryptocurrency chart, doing nothing but profiting from retail stop-losses?
It doesn't take a genius to realize how stupid this sounds, but as I said, these concepts are indeed effective; the market often breaks previous highs/lows and reverses at these levels, the market returns to the 'order block' and continues in the intended direction.
Let's take a look at why this is the case.
Realistic Expectations
Before we delve deeper into the strategy itself, you need to understand some basic concepts and why most online traders sharing 'SMC' trades do not make money in actual trading.
It is also worth mentioning that this is entirely 'SMC trader territory,' because while I was researching for this article, I browsed some of ICT's content, and he actually does not advocate this type of trading; I also found some of his videos on risk management that contain some very practical advice.
So, why can't you, like those people on Instagram, make 10R from every trade?
If you are relatively new to trading, R represents the risk units you are taking.
If you see someone online talking about a 3R trade, it means they made three times the risk return; in other words, if their risk was $1,000, then they made $3,000.
A very simple concept that most of you are probably familiar with, it has been discussed many times online and on this site. If you want to learn more details, remember to read the article about risk management.
The problem with most SMC traders you see online is that they always tend to post trades with stop-losses just a few pips away but with huge returns.
The simplest explanation for why making 10R trades is unrealistic is if we temporarily assume it is realistic.
Trading on a 1-minute chart provides quite a few trading opportunities every day, assuming you are simultaneously monitoring 2 to 3 markets, and most days there will be at least two trading opportunities.
According to this logic, there are about 250 trading days in a year, so assume you will make 500 trades throughout the year. Each trade has a risk-reward ratio of 10:1, and you are correct 50% of the time.
Starting with a €10,000 account, you would end the year with a profit in the 13 figures, and now you are the richest person in the world, congratulations.
A viewpoint I see online is that these high-return trades have very low win rates, around 20-30%, but due to the very large risk-reward ratios, they remain a profitable strategy.
Indeed, a strategy with a 10:1 risk-reward ratio and a win rate of only 20% can be profitable in the long term, but if you look below, you will find that one of the capital curves experienced 38 consecutive losses.
Imagine being able to endure 38 consecutive losses at your computer without being emotionally affected, not breaking any rules, and avoiding making larger losses. Can you really do that?
If we simulate again, considering a strategy with a 50% win rate and a 2.5 risk-reward ratio, this is much more realistic than the previous assumption, and you will see that you could still experience 13 consecutive losses.
Even so, it can be very difficult to bear, but if you have built a strong trading record and have confidence in your system, you will find that enduring these consecutive losses is not that hard, rather than always sitting in losses, hoping to hit a 'winning' trade that returns you 10 times the risk.
But okay, ultimately, whether to focus on steadily building your capital curve or to aim for a 'home run' on every single trade is your own choice.
If you are trading lower timeframes, such as a 1-minute chart or tick chart, you will be using quite large positions and setting very tight stop-losses.
This is a common trading setup for SMC traders; the market breaks through the resistance level to 'grab liquidity' and then shows a breakdown of the downward structure.
The idea of this trade is to short below the last 1-minute bullish candle before the sell-off, targeting the previous low.
In this example, the trade did not succeed, and that is perfectly fine; not all trades will be profitable, but we need to delve deeper into the risk management of this setup to understand the issues involved.
I know most of you trade smaller accounts, but of course, everyone hopes to 'succeed' one day and trade with large funds. Therefore, assume in this situation you are trading with a $100,000 account and the risk is set at 1%.
Because your stop-loss is only $27, just 0.13% away from the entry price, to make this $27 movement worth $1000, you need to short quite a bit of Bitcoin; specifically, about $750,000 or 37 BTC.
To better illustrate this, suppose you short 37 BTC at a price of $20,287, totaling $750,619. If the BTC price reverses to $20,314, the value of these 37 BTC becomes $751,618, meaning you now owe the exchange $1,000 because you borrowed money to short Bitcoin.
Of course, the entire process is automated, and if you set a stop-loss at $20,314, the exchange will automatically close your position, and you will lose that $1,000, after which you can continue to the next trade, or... can you really continue?
As you can see, this is a footprint chart, which simply shows that the numbers on the left represent sell orders, and the numbers on the right represent buy orders.
For more information about footprint charts, you can read this article.
You may have heard this trading viewpoint: every seller must have a buyer, and vice versa. So, if you sell Bitcoin worth $750,000 and want to close your position, you need to find someone willing to buy it.
In the chart above, the red line represents the stop-loss you set at the exchange, while the blue line above it shows where you would actually close the position, as the market must first fill the gap of 37 BTC. This is known as slippage, and in this case, you would encounter about $10 of slippage.
If your original stop-loss is less than $30, this slippage is quite significant, leading to an overall additional loss of 0.3% (i.e., $300), not including fees. From this example, it can be seen that if you trade on extremely low timeframes, your 1% risk rarely truly remains at 1%, especially when trading with larger accounts.
And this example is used on an ordinary trading day; during high-impact news events, market makers withdraw liquidity before the event occurs, and the situation may be worse.
I discuss this in the video below: video link
Trading on a 1-minute chart is not unrealistic, especially in most cases if you are trading a liquid market. But you still need to be aware of liquidity, spreads, and fees. Targeting 10R on every trade and treating it as a normal trading goal is unrealistic.
Even if you find a strategy that can achieve 10R trades at a 20% win rate, sooner or later, you will encounter a long period of losses, which you may not be able to bear, especially if you are trading with more capital.
Trading itself is already stressful enough and requires a lot of focus and investment; if you know these are low-probability trading opportunities, there is no need to make it harder on yourself by trying to hit a 'home run' with every trade. Making money in trading is a long-term accumulation, not relying on one lucky trade.
Market Makers
The core idea of the entire strategy largely relies on 'market manipulation,' i.e., the 'manipulation' triggered by market makers.
The advantage of this strategy lies in the fact that market makers are an 'evil entity' that manipulates the market all day and triggers retail investors’ stop-losses. But in reality, this is not the job of market makers. The responsibility of market makers is to provide market liquidity, not to influence market trends through malicious manipulation.
If you look at the market depth of any trading instrument, you will see quotes on both the bid and ask prices.
Because the market depth for popular markets like Bitcoin, E-mini S&P 500, Nasdaq, gold, crude oil, or currencies is often provided by market makers, you can usually easily enter and exit these trades with almost no issues.
The chart above shows the market depth of the Euro Stoxx 50, a popular market traded on Eurex.
You can see that currently, there are 464 contracts being bought at 3516, while there are 455 contracts being sold at 3517.
If you want to enter the market with a long position, you have two options:
1. Market Order: This leads to crossing the bid-ask spread, and you will immediately enter a trade at the price of 3517, while the market is actually trading at 3516, so you will immediately lose 1 tick.
2. Limit Order: You can place a limit order at 3516, but if you only place 1 contract, this order will queue behind, and the market depth will show buyers at 467 contracts, so you need to wait for the order to be filled.
If you only trade 1 contract, in this market, a 1 tick spread means a cost of €10. Many retail traders tend to overlook this and directly use market orders because they want to enter trades immediately. And this is where market makers come into play.
The strategy of market makers is known as the 'delta-neutral strategy,' in other words, market makers do not care about the direction of market movement; they only focus on providing liquidity on buy-sell quotes and earning profits through spreads.
Because if I buy using a market order at 3516 and it ends up filling at 3517, then on the other side, someone has shorted at 3517 and immediately made a profit of 1 tick.
The image above presents a very simplified example of market making.
In this example, the market maker sells 1 contract at a price of $11, taking a spread of 1 tick, but now he/she holds a short position of 1 contract.
As I mentioned earlier, the strategy of market makers is a delta-neutral strategy, so market makers do not wish to hold positions in the underlying asset. So now they need to buy 1 contract at $9 to close the short position and earn profits again through the spread.
Of course, in the real world, markets can quickly fluctuate within a short period, so market makers might accumulate more long or short positions than they actually want, and they need to manage these positions accordingly.
Nowadays, market makers usually operate through algorithms, with many companies specializing in market-making.
Of course, there is manipulation in financial markets. For example, in the forex market, some brokers widen the spreads, while in the cryptocurrency market, many operations rely on 'insider information,' similar to the stock market.
There are indeed many manipulative behaviors in the forex market, such as some brokers engaging in 'front running' before customers place orders, but these manipulative behaviors are different from the type of manipulation that ICT/SMC traders believe involves 'someone constantly breaking stop-losses every day.'
Liquidity and Order Flow
Order Flow
Regarding ICT and SMC, the terms 'liquidity' and 'order flow' are often mentioned.
First, it should be clarified that this strategy is entirely based on price action. SMC traders do not use any Level 2 data or other order flow tools, except for pure price action. When you hear them mention 'order flow,' they are simply referring to the direction of market liquidity or the overall trend.
This is not the true meaning of order flow, although it may appear in ICT/SMC traders' vocabulary, overall, 'true order flow' refers back to the DOM (Depth of Market) I have shown previously.
Order flow studies the relationship between limit orders (liquidity) and market orders; it is the most primitive form of price you can observe in the market.
The purpose of this article is not to explain the unique relationship between limit orders and market orders; I have already discussed this in my article about order flow trading.
For the purposes of this article, you should understand that order flow is the most refined observation perspective in the market, and traders can extract important information from order flow using tools like DOM, Footprint, Time and Sales, etc.
Liquidity
The concept of liquidity plays a key role in ICT/SMC trading.
Liquidity zones are typically located above and below the horizontal/diagonal lines.
These areas are where retail traders set their stop-losses, which are usually exploited by 'smart money.'
Again, the reasons why these price fluctuations happen are actually much duller than attributing them to some hidden force.
It all comes down to order flow and how market participants interact at specific price levels.
Of course, the simpler the better. If you trade using Elliott waves, Gann boxes, or other highly subjective strategies, you will find it difficult to identify price levels with high market interaction.
But for those who trade using simple horizontal lines or diagonal lines, or even common moving averages (50, 100, 200), you will find that there is indeed strong interaction at these levels.
All financial markets operate in a two-sided auction, which means that there must be a seller behind each buyer and vice versa. When the market reaches similar support/resistance (S/R) levels, it usually triggers two types of events.
Of course, there are indeed stop-losses triggered, but in many cases, there are also traders and algorithms attempting to break through this level, pushing the price to continue.
If you look at the EUR/USD chart above, when the price breaks below the support line, it triggers stop-loss orders for long positions, and these stop-loss orders are sell orders. In addition, some new sell orders enter the market, which come from traders trying to trade trend continuation.
Because every buyer must have a seller (and vice versa), this intense selling pressure provides a perfect environment for large funds to enter the market long.
As you can see above, this is the footprint chart for EUR/USD (6E futures contract), and you can clearly see this dynamic.
When the price breaks below a low, the selling activity (including stop-losses and new orders flooding in) significantly increases, but once the market reaches the low, large buyers suddenly enter and begin filling their long orders.
Why does it happen right here?
This returns to the earlier example of trading the Euro Stoxx DOM; if you use a market order, you are essentially crossing the bid-ask spread, instantly entering with a 1 tick pullback. Trading one contract in these European futures contracts would cost you $6.25, which is one tick of that product.
If you only trade 1-2 contracts, this loss is bearable; but what if you want to buy 100, 500, or even 1000 contracts?
As you see in the footprint chart, there is a buyer who filled 130 contracts at one price; if he traded only in thin liquidity, he might lose within a few ticks due to the bid-ask spread, easily exceeding $1,000.
However, if they are a bit smarter and choose to trade in areas with greater market participation, they can complete their orders without slippage.
When sellers see their new short positions being absorbed by large buyers, and the price no longer declines, they begin to cover their positions, turning sell orders into buy orders, pushing the price up.
From the perspective of order flow, each situation is different. Sometimes there are large limit orders hanging around the levels, indicating that new market participants want to enter the market rather than stop-loss orders, as you cannot see stop-loss orders on the DOM; this is a common misconception among many novice traders.
These heat maps are often the go-to tool for many new traders who believe they are a universal trading tool.
I personally do not believe this, as there are many situations where buyers or sellers place fake orders in the DOM that they do not intend to execute, just to create confusion.
Once the price starts getting close to these large hanging orders, many small traders will buy in early, only to see these orders pulled at the last moment while the market breaks through, as those placing fake orders are executing opposing orders.
I delve deeper into this topic in my article on (Market Microstructure), which is a great resource for understanding these market dynamics.
Ultimately, believing that the market is merely probing horizontally or vertically to execute stop-loss bombardment, from 'smart money' to retail traders, is quite ridiculous.
At these levels, what actually happens is far more than just this; stop-loss triggers are usually just a small part of it.
If you decide to spend more time researching order flow, you will see this firsthand; you can join Tradingriot Bootcamp, where all the details of the techniques and trade execution will be explained.
AMD/Power of Three
I noticed a very popular pattern that is often shared online, which is the 'Power of Three' or AMD (Accumulation, Manipulation, Distribution).
Initially, it was proposed as a 'false breakout' pattern, usually occurring at the London open, breaking the boundaries of the Asian session, but it can also be applied to different time frames.
This is a good pattern that can often be observed because prices tend to push toward the side of the market with lower liquidity, observing how market participation is, but again, I would not view it as some sort of evil manipulation.
Similar to previous examples, markets often break previous highs/lows, triggering stop-loss orders while attracting more participants. When prices quickly rebound and show characteristics of a V-shaped reversal, it usually indicates that there hasn't been enough time to accept at the new price level, and this may lead to a 'false breakout' and signal a potential reversal.
Again, by closely observing order flow and market participation at lows, we can find a logical explanation.
Another very popular concept is order blocks, these magical rectangles are used in trend continuation, and once the price touches them, it seems to bounce back from these blocks.
These concepts have had many different names and explanations over the years.
In ICT/SMC terminology, the main point is that these areas are where smart money fills orders. Honestly, this is not entirely incorrect, but as always, the notion of smart money vs retail traders makes things sound much more mysterious than they actually are.
As mentioned earlier, large traders cannot execute their positions arbitrarily; they need to trade in areas with sufficient liquidity and favorable conditions to avoid additional costs.
If you look at the above example, suppose you want to sell 1000 lots of GBPUSD. Would you sell in the red boxed area where the price is dropping and buyers are scarce, or would you sell in the green boxed area where the price is rising and there are sufficient sellers?
Of course, the green boxed areas are clearly more significant.
