Where Traders Place their Stops and Why it Matters

In a recent episode of Tales from the Trenches, we highlighted 4 key differences between professional traders and retail traders.

One of these differences was that professional traders don't rely exclusively on charts. They use "outside information" like sentiment, seasonal or time-based influences, demand/supply dynamics, stop loss clusters and other pieces of information that represent an edge.

Today you will learn about Stop Loss Clusters and why they represent an edge.

The Job of Trading

Trading is challenging: it requires us to go against almost everything we are taught:

a) there are as many approaches as there are traders;

b) decisions must be made in conditions of uncertainty (there is never a “right” answer);

c) you need to build on the experience and knowledge of others, in order to avoid unnecessary losses, wasted time, ongoing frustration;

d) you need to let your winners run (which is much more difficult than cutting losses);

but most importantly

e) profit is made by intercepting larger flows of capital. Unless of course you are trading a small-cap where it is entirely possible to move the market by yourself. But if you are trading need to “team up” with many other players.

Liquidity Pockets

Stop loss clusters help us do just that because stop losses represent much needed liquidity, which helps larger players execute their orders with limited slippage. Large traders cannot simply accumulate or distribute a large position whenever they wish. Instead they have to look for those places where liquidity is aggregating and stops are helping them in an indirect way.

Since people are creatures of habit, they will usually put their stops in the same spot. And sometimes, the retail crowd is accompanied also by larger traders which have stops in the same place. But those stop orders are, effectively, liquidity that can be used by larger traders.

If you are managing a Multi-Billion dollar fund, you will move the market when you operate, unless you can find “pockets” of liquidity that help you remain anonymous, and operate without generating too much havoc. As usual, a chart is worth 1000 words:

Buy stop levels above current price; Sell stop levels below current price.

Large traders use, typically, larger time frames so this is a daily time frame of EURUSD. Major swing points on a major chart. The first place to look for liquidity. And it's also the first place to keep an eye on what happens. Because following with the same logic, if large traders are active at these levels, then at these levels we can actually understand something. We have the first clues as to what the aggregate market knows and thinks:

a) if an evident stop level gets broken (hurdled) and price continues, that means the flow has become indigestible to the diverse participants and the price structure changes. This is usually driven by some kind of event or strong fundamental reason.

b) if an evident stop level gets faded (a break, followed by a quick reversal) that means the flow is still in balance and it demonstrates that the fundamentals are still not strong enough to break the structure.

And that is why these evident stop levels (either buy stops or sell stops), once hurdled, start to generate opposite orders next time they are tested. The price structure changes, the markets react and when the level is tested once more, it confirms (or doesn't confirm) this break. But either way, these levels are the most evident levels to observe the actions of large players.

Stop Clusters

A good way to understand the importance of stop clusters and why they are positioned in certain places is to first review the concept of support and resistance.