Smart Money Trading—How to Identify Swing Highs and Lows

Financial markets often exhibit repetitive patterns influenced by institutional participants, commonly referred to as "smart money." These entities, including large banks, hedge funds, and other financial institutions, possess significant resources and market influence, enabling them to steer price movements over time.

Recognizing these structures is paramount, as you unveil the phases of accumulation, trend progression, and reversals. Align your positions with the market's direction and you’ll enhance your decision-making and avoid common pitfalls.

What Is Market Structure

Market structure is the framework upon which price movements are built, primarily defined by liquidity levels and swings that indicate trend direction.

Swing Highs and Swing Lows

Swings serve as the fundamental components of market structure:

• Swing High: this occurs when a price reaches a peak, flanked by lower highs on both sides.
• Swing Low: this forms when a price hits a trough, with higher lows on either side.

These swings are pivotal in identifying potential reversals, liquidity zones, and assessing trend strength.

A consistent formation of higher highs and higher lows signals an uptrend, whereas lower highs and lower lows suggest a downtrend.  

For a swing point to be validated, the price must break the previous swing high or low with a decisive candle body close, confirming a shift in market structure. Merely wicking above a swing high or below a swing low without a close is considered a liquidity sweep rather than a structural change.

A structural swing point is only valid if the previous swing high or low has been broken with a candle body close, confirming a shift in market structure. If price only wicks above a swing high or below a swing low without a close, it is considered a liquidity sweep and not a structural shift.

The Role of Liquidity in Market Movements

Liquidity is the lifeblood of financial markets, driving price movements and creating opportunities for traders.

Liquidity Pools and Institutional Influence

Major liquidity pools often form around swing highs and lows:

• Sell-Side Liquidity (SSL): located below swing lows, where long traders place stop-loss orders, creating a pool of sell orders.
• Buy-Side Liquidity (BSL): found above swing highs, where short traders place stop-loss orders, resulting in a pool of buy orders.

Institutional traders, or smart money, target these liquidity zones to execute large orders. Since they trigger these stop-loss orders, they can create the necessary liquidity to enter or exit substantial positions, often leading to price reversals that catch retail traders off guard.

Find more details about price reversals in this webinar:

Liquidity Sweeps and Market Manipulation

A common tactic employed by institutions is the "liquidity sweep," where the price briefly moves beyond a key swing point, triggering stop-loss orders before reversing. This maneuver allows institutions to enter positions at favorable prices, exploiting the liquidity provided by retail traders' stop orders.

If you want to avoid manipulation traps, it’s essential that you understand this behavior. Recognizing potential liquidity sweeps helps you anticipate false breakouts and position yourself accordingly.

Combining liquidity analysis with an understanding of market structure offers traders a comprehensive view of market dynamics.

Identifying Key Structural Points

Key structural points, such as validated swing highs and lows, serve as reference points for:

• Trend Identification: determining the current market trend direction.
• Entry and Exit Points: establishing optimal points for entering or exiting trades.
• Risk Management: setting stop-loss levels to manage potential losses effectively.

As you analyze how price interacts with these structural points, you can gain insights into potential future movements and make informed trading decisions.

How to Avoid Manipulation Traps

Here’s how to steer clear of traps set by smart money:

1. Be skeptical of breakouts: not all breakouts indicate a new trend; some are engineered to trigger stop-loss orders.
2. Wait for confirmation: ensure that breakouts are accompanied by strong volume and a decisive close beyond key levels.
3. Analyze order flow: monitoring order flow can provide insights into institutional activity and potential manipulation.

Practical Application: Analyzing Historical Price Charts

If you want to thoroughly understand market structure and liquidity, practice on historical price charts:

• Identify structural swing highs and lows: mark these points to visualize market structure.
• Spot liquidity sweeps: look for instances where the price briefly breaches a swing point and then reverses.
• Locate liquidity pools: determine areas with clustered stop-loss orders, indicating potential liquidity zones.

The Impact of High-Frequency Trading and Algorithms

High-frequency trading (HFT) and algorithmic strategies play a significant role. These automated systems can execute large volumes of trades in milliseconds, often targeting the same liquidity zones as traditional institutional traders.

The presence of HFT can lead to increased volatility around key structural points, making it imperative to account for these factors in your analysis. Understanding the influence of algorithms can help you anticipate rapid price movements and adjust strategies accordingly.

Final Thoughts

Learn to integrate knowledge of market structure, liquidity behavior, and price action, and you’ll gain a significant edge in understanding price movements. Recognizing institutional manipulation and the impact of algorithmic trading helps you make strategic trading moves, avoiding common retail pitfalls. 

Keep in mind that you can use swing points to:

• Identify market structure shifts and trend direction.
• Set stop-loss levels below swing lows in uptrends and above swing highs in downtrends.
• Determine key liquidity pools where institutional traders may drive price action.