What Is Liquidity in the Financial Markets?

Education

Liquidity has become one of the most common terms thrown around in trading communities — and for good reason. It plays a central role in how markets move, particularly in heavily institutionally-driven markets like forex, indices, and stocks. But for all the buzz around the word, it is often explained poorly or treated as a more mysterious concept than it actually is.

This article breaks it down clearly: what liquidity is, why it matters, how banks and financial institutions use it, and how you can apply it as a supply and demand trader.

If you are brand new to trading or forex, this is a more advanced concept — we recommend working through our forex beginners guide first before diving in here.

We also have a full video breakdown on YouTube if you prefer to watch rather than read: https://youtu.be/eYs1gdtMTyo

Liquidity Is Simply Resting Orders in the Market

At its core, liquidity is a collection of orders sitting in the market at specific price levels. These can be limit orders, stop loss orders, stop limit orders, or concentrations of market orders that are likely to be triggered when price reaches certain levels of supply or demand.

When supply and demand traders refer to liquidity, they are typically talking about where orders are sitting in anticipation of a bank or financial institution (BFI) either absorbing those orders to build a position, or targeting them to fuel a move in a specific direction.

The key insight is this: certain price action patterns do not just indicate likely turning points — they actively build and attract liquidity at key levels. Understanding which patterns create liquidity, and where it is sitting, gives you a meaningful edge in reading what the market is likely to do next.

Liquidity Helps You Anticipate Where Price Is Heading

On its own, liquidity does not tell the whole story. But when used in combination with higher timeframe market structure, supply and demand zones, and order flow, it becomes a powerful tool for forming high-quality trade ideas.

Markets do not move randomly. BFIs — the banks and institutions with enough capital to genuinely move price — need liquidity to build and exit positions efficiently. That need creates predictable patterns in price action that, once you learn to read them, give you a clearer picture of institutional intent than structure analysis alone.

This is particularly useful in ranging market environments or on mid-timeframes where structure can be misleading. Liquidity provides an additional layer of context that helps you avoid common traps and align yourself with the institutional move rather than against it.

Liquidity Is Fuel for Market Movement

This is where it starts to get counterintuitive. Liquidity is not just a target — it is also the fuel that makes large moves possible.

BFIs operate at a scale that creates a specific problem: they cannot simply enter a full position at a single price without pushing price away from their own entry. If a large institution tries to buy a significant position in one go, the buying pressure moves price up before they have finished filling — resulting in a poor average entry. To solve this, they need liquidity on the other side of their order. They need sellers to absorb their buy orders, and vice versa.

This is why liquidity pools — particularly those sitting above highs or below lows where stop losses cluster — are so important to institutional order flow. They provide the volume BFIs need to enter or exit positions at scale without creating excessive slippage.

A Lack of Liquidity Creates Volatility

It is worth understanding the other side of this equation. In markets with low liquidity — certain cryptocurrencies, OTC penny stocks, or forex pairs during off-hours — there are not enough resting orders to absorb large transactions. The result is violent, erratic price movement.

This is why you see massive wicks and spikes in thinly traded assets, or why gaps appear on instruments after major news events. There simply are not enough orders in the book to absorb the flow, so price has to move aggressively to find the next available liquidity pocket.

In the forex market, this is less of a daily concern given the sheer volume of the market — but it does occur around high-impact news releases, which is why many experienced traders avoid holding positions into those events.

The Three Types of Liquidity

Structural Liquidity

Structural liquidity rests above major pivot highs and below major pivot lows — specifically at the points where price broke structure. The logic is straightforward: if price pivoted cleanly from a level, there will be a build-up of stop losses from traders who entered based on that level. Buyers who went long from a demand pivot will have their stops sitting just below it. Sellers who entered from a supply pivot will have stops sitting just above it.

BFIs can use these clusters in two ways: to absorb orders and build a position (using the stops as the liquidity they need), or to deliberately target and run those stops to push price in their intended direction before the real move unfolds.

Buy Side Liquidity (BSL)

Buy side liquidity refers to the build-up of orders sitting above a range high or swing high — specifically the stop losses of short sellers and the entry orders of breakout buyers. When price runs above a high and triggers these orders, it creates a burst of buying pressure. BFIs can use this either to offload long positions into that buying pressure, or to absorb those buy orders as the counterparty for their own short position.

Sell Side Liquidity (SSL)

Sell side liquidity is the mirror image — orders sitting below a range low or swing low, where long traders have placed their stops and breakout sellers have placed their entry orders. When price sweeps below a low and triggers these orders, it creates a burst of selling pressure that BFIs can use to either exit short positions or absorb as the counterparty for building a long.

How to Use Liquidity as a Supply and Demand Trader

Understanding where liquidity is building is essential for avoiding the traps that consistently catch retail traders — and for positioning yourself alongside institutional flow rather than against it.

Liquidity Traps

The most common trap is a bullish or bearish liquidity sweep. On mid to higher timeframes, this appears as a clear sweep of a structural or pivot point — price breaks above a supply level or below a demand level, triggering the stops of traders who had positions at that level, before reversing sharply in the opposite direction.

This traps two groups simultaneously: traders who used the swept level as a point of interest and got stopped out, and breakout traders who entered in the direction of the sweep expecting continuation. Both groups lose. The BFI gets filled.

Liquidity as Inducement

Inducement is a subtler variation. Here, a weaker level of supply or demand sits in front of a stronger one, drawing traders in early before price continues to the higher timeframe level.

For example: a 15-minute supply zone sits just below a 4-hour supply zone. Price taps the 15-minute zone, inducing short entries, then sweeps through it — stopping out those early sellers — before tapping the 4-hour supply and reversing bearish. The weaker level acted as inducement for the stronger one.

The same logic applies in reverse on the demand side. Learning to distinguish between a genuine point of interest and an inducement level is one of the more nuanced skills in reading liquidity effectively.

Liquidity to Target

The third application is using liquidity as a directional target. Rather than expecting a sweep and reversal, here you are anticipating that price will run liquidity and continue in that direction — because a BFI has already built a position and is now pushing price to collect liquidity that fuels their intended move and helps them offload at profit.

In practice, this means identifying a pool of buy side or sell side liquidity in the direction of the higher timeframe trend, and using that as your take profit or directional bias rather than expecting price to stall at the nearest structural level.

Putting It Together

Liquidity is not a standalone signal. It is most powerful when layered with higher timeframe trend, clear supply and demand zones, and an understanding of what BFIs are likely doing at any given point in the market.

Used correctly, it helps you avoid getting caught in traps, identify where the real move is likely to come from, and align your entries with institutional intent rather than against it. That said, developing a genuine feel for liquidity takes time and screen time — reading it well is a skill that builds through deliberate practice, not just conceptual understanding.

At PTM we cover liquidity in depth as part of our core curriculum, including how to identify all three types in real market conditions and how to integrate them into a complete trade plan.