How to become smart money?

Original Title: 《Breaking Down Popular Price Action Strategies (Smart Money Concepts and ICT Trading)》

Author: abetrade, Crypto Kol

Compiler: zhouzhou, BlockBeats

Editor's Note: This article mainly explains that market trading is not entirely controlled by "smart money" as some popular trading theories suggest, but is 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 (reorganized for readability):

If you have been in the trading circle for a while, you may have noticed that there is always a "trendy" strategy each month, in other words, a trading system that is widely discussed. Besides receiving countless private messages on Twitter asking about smart money concepts, you can see these "SMC" traders on various platforms.

Social media platforms like Instagram, YouTube, and Twitter are filled with retrospective TradingView charts showing trades on a 1-minute timeframe with returns of 10-20R (risk-reward ratio). I am writing this article to reveal some of the real reasons behind market movements, why the market fluctuates, because I am truly fed up with hearing statements like "market makers manipulate the market."

Strategy Concepts

First, what are Smart Money Concepts (SMC)?

SMC trading is a derivative form of the teachings of inner circle traders (ICT). Simply put, their trading method 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 again later.

The reason these concepts have become very popular is mainly because they are "cool."

New traders around the world sit at home, losing money on MetaTrader 4, and see terms like "smart money" and "manipulation," suddenly feeling like they are no longer retail traders; they now fully understand how the financial market operates because they can see the "behind-the-scenes" operations happening every day.

But the fact is, the "ICT concepts" are indeed effective, but the reasons they are effective are far more mundane than they appear.

One very popular thing that ICT and SMC traders do is to rename and complicate things, making them sound more appealing, leading you to feel that you now possess insider information that others do not know.

If you watch this video by Chris Lori, which is over a decade 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 concepts of "manipulation" and "market makers." I leave it to you to judge; just ask yourself one question: who do you think would sit in a bank all day staring at a 1-minute USD/CHF chart or a cryptocurrency chart, doing nothing but making money off retail traders' stop losses?

It doesn't take a genius to realize how foolish that sounds, but as I said, these concepts are indeed effective; the market often breaks previous highs/lows and reverses at these points, returning to "order blocks" and continuing in the intended direction.

Let's take a look at why this is the case.

Realistic Expectations

Before we delve into the strategy itself, you need to understand some basic concepts and why most traders sharing "SMC" trading online do not make money in actual trading.

It is also worth mentioning that this is entirely a "SMC trader issue," because while researching for this article, I browsed some of ICT's content, and he does not actually advocate this type of trading; I also found some of his videos on risk management, which contain very practical advice.

So, why can't you make 10R from every trade like those people on Instagram?

If you are relatively new to trading, R represents the unit of risk you are taking.

If you see someone online talking about a 3R trade, it means they made three times their risk; in other words, if their risk was $1,000, then they made $3,000.

A very simple concept that most of you are likely familiar with, it has been discussed many times online and on this site. If you want to know more details, remember to read the article on risk management.

The problem with most SMC traders you see online is that they always tend to post trades with very tight stop losses but huge returns.

The simplest explanation for why making 10R trades is unrealistic is that if we temporarily assume it is realistic.

Trading on a 1-minute chart provides quite a few trading opportunities each day; let’s assume you are watching 2 to 3 markets simultaneously, and most days you will have at least two trading opportunities.

Following this logic, there are about 250 trading days in a year, so let’s 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 13-digit profit, and now you are the richest person in the world, congratulations.

One viewpoint I have seen online is that these high-return trades have a very low win rate, around 20-30%, but due to the very large risk-reward ratio, it is still a profitable strategy.

Indeed, using a 10:1 risk-reward ratio strategy with a win rate of only 20% can be profitable in the long run, but if you look below, you will find that one of the equity curves shows 38 consecutive losses.

Imagine being able to endure 38 consecutive losses in front of your computer without being emotionally affected, without breaking any rules, and avoiding making larger losses?

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 would be very difficult to endure, 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 sitting in losses, hoping for a "winning" trade that pays you 10 times your risk.

But well, ultimately, whether to focus on steadily building your equity curve or to try to hit a "home run" with every trade is your own choice.

If you are trading lower timeframes, like 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 among SMC traders; the market breaks through a resistance level to "grab liquidity," and then a downward structure breaks.

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 every trade 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 larger funds; therefore, let’s assume in this case you are trading with a $100,000 account and the risk is set at 1%.

Since your stop loss is only $27, just 0.13% away from the entry price, to make this $27 move worth $1,000, you would need to short quite a bit of Bitcoin; specifically, about $750,000 or 37 BTC.

To illustrate this better, let’s assume you short 37 BTC at a price of $20,287, totaling $750,619. If the BTC price moves against you 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; if you set a stop loss at $20,314, the exchange will automatically close your position, and you will lose that $1,000, then you can move on to the next trade, or… can you really move on?

As you can see, this is a footprint chart, which simply shows that the numbers on the left represent sell orders, while the numbers on the right represent buy orders.

For more information on footprint charts, you can read this article.

You may have heard this trading perspective: every seller must have a buyer, and vice versa. So, if you sell $750,000 worth of Bitcoin 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 your position because the market must first fill the gap of these 37 BTC. This is known as slippage, and in this case, you would encounter about $10 of slippage.

If your original stop loss was less than $30, this slippage is quite significant, resulting in an additional overall loss of 0.3% (i.e., $300), not including fees. This example shows that if you trade on extremely low timeframes, your 1% risk rarely stays at 1%, especially when trading with larger accounts.

Moreover, this example is used on an ordinary trading day; during high-impact news events, market makers may withdraw liquidity before the event, making the situation even 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 in 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 can find a strategy that allows you to make 10R trades with 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 funds.

Trading itself is already stressful enough and requires a lot of focus and commitment; if you know these are low-probability trading opportunities, there is no need to make it harder for yourself by trying to hit a "home run" with every trade. Making money in trading is a long-term accumulation, not relying on a lucky trade.

Market Makers

The core idea of the entire strategy largely relies on "market manipulation," which is triggered by market makers.

The advantage of this strategy lies in the belief that market makers are "evil entities" that manipulate the market all day and trigger retail investors' stop losses. But in reality, this is not the job of market makers. The duty 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 the bid and offer prices.

Since the market depth of popular markets like Bitcoin, E-mini S&P 500, Nasdaq, gold, crude oil, or currencies is usually provided by market makers, in most cases, you can easily enter and exit these trades with almost no issues.

The chart above shows the market depth of Euro Stoxx 50, a popular market traded on the Eurex exchange.

You can see that there are currently 464 contracts to buy at 3516 points and 455 contracts to sell at 3517 points.

If you want to enter the market with a long position, you have two options:

1. Market Order: This will cause you to cross the bid-ask spread, and you will immediately enter the trade at 3517, while the market is actually trading at 3516, so you will immediately incur a loss of 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 467 contracts on the buy side, so you will need to wait for the order to be filled.

If you are only trading 1 contract, in this market, a 1 tick price difference means a cost of €10. Many retail traders tend to overlook this, and they directly use market orders because they want to enter the trade immediately. And this is where market makers come into play.

The strategy of market makers is called "delta-neutral strategy," in other words, market makers do not care about the direction of the market trend but focus on providing liquidity on the bid and ask quotes and profiting from the spread.

Because if I buy at the market order at the price of 3516 and end up filling at 3517, then on the other side, someone is shorting at 3517, immediately making a profit of 1 tick.

The image above shows a very simplified example of market making.

In this example, the market maker sells 1 contract at $11, collecting a 1 tick spread, but now he/she holds a short position of 1 contract.

As I mentioned earlier, the strategy of market makers is delta-neutral strategy, so market makers do not wish to hold a position in the underlying asset. Therefore, they now need to buy back 1 contract at $9 to close their short position and earn profit again through the spread.

Of course, in the real world, the market may fluctuate rapidly in a short time, so market makers may accumulate more long or short positions than they actually want, and they need to manage these positions accordingly.

Nowadays, market makers typically operate through algorithms, and many companies specialize in market making.

Of course, there are indeed manipulative behaviors in financial markets. For example, in the forex market, some brokers widen the spreads, and in the cryptocurrency market, many operations rely on "inside information," similar to the stock market.

In the forex market, there are indeed many manipulative behaviors, such as some brokers engaging in "front running" before clients place orders, but these manipulative behaviors are different from the type of manipulation that ICT/SMC traders believe involves "someone breaking stop losses every day."

Liquidity and Order Flow

Order Flow

Regarding ICT and SMC, the terms "liquidity" and "order flow" are frequently mentioned.

First, it is important to clarify that this strategy is entirely based on price action. SMC traders do not use any Level 2 data or other order flow tools, other than 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 the vocabulary of ICT/SMC traders, overall, "true order flow" refers back to the DOM (Depth of Market) I showed earlier.

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, as I have already discussed this in my article on order flow trading.

For the purposes of this article, you should understand that order flow is the most refined perspective for observing 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 areas are usually located above and below horizontal/diagonal lines.

These areas are where retail traders set their stop losses, which are often exploited by "smart money."

Again, it is emphasized that the reasons for these price fluctuations are far more mundane than attributing them to some hidden force.

It all comes down to order flow and the interaction of market participants 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 dense market interactions.

But for those using simple horizontal 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-way auction, meaning every buyer must have a seller behind them, 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 being triggered, but in many cases, there are also traders and algorithms trying to break through this level, pushing prices to continue moving.

If you look at the EUR/USD chart above, when the price breaks below the support line, it triggers stop loss orders from long positions, which are sell orders. In addition, there are also new sell orders entering the market from traders trying to execute trend continuation trades.

Because every buyer must have a seller (and vice versa), this intense selling pressure creates a perfect environment for large funds to enter and go long.

As you can see above, this is a footprint chart of EUR/USD (6E futures contract), where you can clearly see this dynamic.

When the price breaks below the low, selling activity (including stop losses and new orders flooding in) significantly increases, but once the market reaches the low, large buying suddenly enters and begins to fill their long orders.

Why does this happen right here?

This goes back to the earlier example of the Euro Stoxx trading DOM; if you use a market order, you are effectively crossing the bid-ask spread, instantly entering 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 are only trading 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 trades in a thin liquidity area, he may incur losses of several ticks due to the bid-ask spread, easily exceeding $1,000.

However, if they are 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 absorbed by large buyers and the price stops falling, they begin to cover their positions, which turns selling pressure into buying pressure, pushing prices up.

From the perspective of order flow, each situation is different; sometimes there are large limit orders hanging above and below levels, indicating that new market participants want to enter, rather than stop loss orders, because you cannot see stop loss orders on the DOM; this is a common misconception among many novice traders.

These heat maps are often the preferred tool for many novice traders, who believe they are a universal trading tool.

I personally do not think so, 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 to approach these large hanging orders, many small traders will buy in early, only to see these orders canceled at the last moment, while the market breaks through because those placing fake orders have been executing opposite orders all along.

I delve deeper into this topic in my article "Market Microstructure," which is a great resource for understanding these market dynamics.

Ultimately, the idea that the market is merely probing horizontally or vertically to trigger stop loss bombardments, from "smart money" to retail traders, is quite ridiculous.

What actually happens at these levels is far more complex than that; stop loss triggers are usually just the smallest part of it.

If you decide to spend more time studying order flow, you will see this for yourself; you can join the Tradingriot Bootcamp, where all the technical details and execution of trades will be explained.

AMD/ Power of Three

I have 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 that usually occurs at the London open, breaking the extremes of the Asian range, but it can also be applied to different timeframes.

This is a good pattern that can usually be observed because prices tend to push towards the side of the market with lower liquidity to see how market participation is, but again, I would not view it as some sort of evil manipulation.

As in the previous example, the market often breaks previous highs/lows and attracts more participants while triggering stop loss orders. When the price quickly rebounds and shows characteristics of a V-shaped reversal, it usually indicates that there was not enough time to accept at the new price level, which may lead to a "false breakout" and signal a potential reversal.

Again, by closely observing the order flow and market participation at the lows, we can find a logical explanation.

Another very popular concept is order blocks, these magical rectangles used in trend continuation, which seem to bounce back from these blocks once prices touch them.

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. To be honest, this is not entirely incorrect, but as always, the narrative of smart money/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 example above, let’s assume you want to sell 1000 lots on GBPUSD. Would you sell in the red box area where the price is falling and buyers are scarce, or would you sell in the green box area where the price is rising and sellers have sufficient counterparts?

Of course, the green box area makes much more sense.