Forex is like a really big game of poker, where different trader groups (players) complete against each other to make profit.
To win at any game, you must first understand the players…
Who your opponents are, and how they play the game.
That’s always the first step.
In forex trading, this is especially important because the market is zero sum – they only way to profit is from others losing.
Plus, in forex, we can’t move the market – our trades are too tiny!
So, we cannot make other lose – we must tag along with those who can.
And who’s the only group capable of making traders lose? That’s right, it’s the banks! Only they have the power to push price and cause traders to lose. That means to make money, we need to understand how they operate in the market.
Because we must tag along with their trades, that’s the only way we can profit.
That’s what most you do already when you hit a winner, you just don’t realize it.
That also why your results are inconsistent – you can’t always time the banks correctly.
While understanding the banks is important, we also need to learn how the other groups trade. Specifically, retail traders – non porfiosnally traders like you and me who trade from home. These are the losers who pay the winners (the banks).
So, by understanding how they trade, we can better gauge when the banks will come into the market and make them lose.
Right, ready to get started?
Retail Traders – Home Traders, Non Professional
To kick off, let’s dive into retail traders.
Or, in other words: the “dumb money.”
The dumb money consists of non-professional traders who trade part-time or as a hobby from phones or computers. These traders make up a significant group in forex and play a large part in causing the price movement seen on a daily basis.
Now, here’s a key point:
Retail traders fall into two separate groups…
- Uninformed retail traders – a.k.a., “dumb money.”
- Informed retail traders – people like you and me.
Most of you reading, whether you realize it or not, fall into the latter – informed retail traders. Any trader using a strategy in a semi-disciplined manner is informed, profitable or not.
You might not use a fantastic strategy or be disciplined 100% of the time, but you trade in a mechanical way, with rules that govern your behavior and decision-making. That’s what “informed” means: trading with rules and discipline.
Informed retail traders show three main traits:
- They DON’T make snap irrational decisions – at least, not most of the time.
- They’re not in the markets for fun or just to gamble and hit a high.
- They use a strategy and trading plan to make their moves.
Does this sound like you?
- YES – Welcome, informed trader!
- NO – Stop the above, and get serious.
If you possess the above traits, you’re an informed trader. Whether you’re losing money, making small profits, or hitting breakeven.
While informed traders are essential, they don’t make up the majority.
In reality, most retail traders fall into the uninformed category (a.k.a., dumb money – or sheep). And understanding how the sheep trade is critial for learning how and why prices move. So, let’s focus on and get a firm grasp of how they trade.
The dumb money are, in short, the sheep being led to slaughter.
These traders have…
- NO trading strategy,
- NO risk management,
- NO technical analysis skills,
- NO chance of becoming profitable.
For all intents and purposes, the dumb money are gamblers who trade on impulse and emotion for cheap thrills rather than using sound rational analysis.
Why are dumb money traders so important?
Because the smart money uses dumb money traders for their own purposes, like placing trades and taking profits. The dumb money impulsively jumps into sharp price moves, and the smart money then capitalizes on the influx of buy and sell orders to enter trades or take profits.
But wait, here’s the kicker…
By reverse engineering how the dumb money trades, you can determine when and where the smart money traders will make trading decisions.
Here’s a closer look at how the dumb money trades…
How Retail Traders Trade: A Breakdown
Figuring out how the ol’ “dumb money” trades might seem like a tough nut to crack, but guess what? Two tidbits about their trading habits make the task a piece of cake!
- They make hasty, emotion-driven decisions, yikes!
- They lack any trading plan or strategy – nope, nada, zilch!
Armed with these two nuggets, you can pinpoint where and when dumb money will jump into the market, and even when they’ll throw in the towel on their losing trades!
Alrighty then, let’s dive into each point for some extra juicy deets…
Key Fact #1: Dumb Money ALWAYS Enter/Close After Steep Price Moves
Here’s a quick question for ya:
When you first started trading, way back as a beginner… how often did you see the price jump higher and think:
“OMG, price is taking off… I MUST get in now!!”
Did you ever feel that FOMO compulsion to jump in?
Do you still feel that way even now?
If YES, fear not – I was the same.
But if you still do, stop… Immediately!
Don’t be a dumb money trader!!
Controlling your emotions and impulsive nature is a must-learn skill in forex. For the dumb money traders, however, it’s a way of life.
Here’s how a dumb money trader trades:
- If the price shoots higher, get long and stay long.
- If the price falls sharply, get short and stay short.
The more dramatic the rise/fall, the more incentivized dumb money traders become in entering long or short to capture the move.
The price is going to the MOON, as they say!
Dumb money traders feel extreme FOMO (fear of missing out).
Unlike informed traders (you and me), the dumb money CANNOT stay on the sidelines when the price takes off for a significant move. The market compels them to enter. Fear and greed wreak havoc in their minds, tempting them to enter even after being burned by the same moves before.
So, looking at a chart…
When a swing first kicks off, most “dumb money” traders won’t jump in.
Why, you ask?
Easy: Price hasn’t climbed high enough.
Keep in mind, “dumb money” traders only make a move when they’re sure the price is definitely gonna keep rising or falling. When does that happen? When price skyrockets or plummets real fast, i.e., after one or more large-range candlesticks form.
Price drops even more, luring more “dumb money” traders to short.
These traders believe the dip signals the beginning of a new, large scale down-move.
As more traders hop on board, price gains even more momentum.
That’s why extra large-range candles (LRC) typically appear right after an initial large-range candle forms – it’s the “dumb money” joining the party! The first LRC tempts a bunch to enter, which then fuels further movement, creating the 2nd and 3rd candles.
Momentum breeds momentum, folks!
Remember the “awareness phase” I mentioned in my book? This part’s all about retail traders catching wind of a reversal or new move in progress.
The “dumb money” traders who got burned by the price flip now think a new uptrend has started; the steep drop makes them believe price is heading the other way, so they all dive in almost simultaneously, trying to ride the wave of a new price move.
Now, the smart money can make their move…
The thousands of “dumb money” traders going short means the smart money (SM) now have a ton of sell orders to use for their own advantage.
In this case, the SM cashes in…
The smart money uses the “dumb money” traders’ selling to take profits off their shorts – which means they have to buy back some of what they sold.
That’s why they need sellers.
Cashing in causes price to rise, leaving the “dumb money” shorts high and dry.
A bunch of them then decide to close – and how do you close a short trade?
Bingo: By buying back what you sold!
Exactly what the SM needs to enter new short positions.
Once enough shorts have closed, the smart money use their orders to sell again. That’s when price does a 180 and starts falling, and the whole process – those 3 phases – repeats itself.
And that, my friends, is how the forex market works.
The smart money outsmarts the “dumb money” again and again.
Now, here’s another key point:
Dumb money traders often close losing trades when they see sharp price moves. Why, you ask? Well, because dumb money associates swift moves with directional certainty.
- When price skyrockets, dumb money believes the rise is definitely going to continue.
- When price plummets, dumb money assumes the fall is bound to go on.
In our example, most dumb money traders initially went long because price seemed bullish. But when did that change? The moment large bearish candles formed, and price took a nosedive. Panicked, the dumb money closed their now-losing longs and entered short, causing the price to fall even further.
In a nutshell:
The sudden decline (those big bearish candlesticks) acted as a catalyst, making the dumb money traders change their minds:
From being ultra-bullish – their initial belief – to heavily bearish, which is why they went short.
By the way, the same thing happens in reverse…
If dumb money traders are long and a steep decline starts, they’ll begin closing their trades to get out, leading to a sharp nosedive.
Here’s an example:
During a strong uptrend, USD/JPY tapers off a bit…
So what are dumb money traders up to now?
Staying long or beginning to close?
Staying long, right?
Dumb money traders stay long because price has only retraced slightly. A few may close, but only a minority – the uptrend is still intact, and price appears super bullish. As a result, most dumb money traders remain long, hoping to catch a continuation.
Fast forward a bit…
Yup, now things have changed.
The minor decline has morphed into a steep drop, with two large bearish candlesticks causing price to plunge deep into the prior swing.
So, I ask again: What are the dumb money longs doing now?
Staying long or beginning to close?
You guessed it – CLOSING!!
Dumb money starts closing because the steep decline signals price has now reversed. But here’s the kicker: It’s the steepness of the decline that makes them close. Those large bearish candlesticks send shivers down their spines, sparking fear and causing them to close at a loss.
Now, let’s compare that to the scenario below…
If price had continued falling gradually, more traders would close, but around 70% would stay long, believing the uptrend is still intact – the decline just seems like a small retracement.
But when a sudden decline forms, that’s when the mindset of most dumb money traders shifts…
They believe price has, in fact, reversed and is heading lower.
So, they scramble to exit their losing longs en masse.
And how do you close a losing long trade?
By selling what you bought, which creates further selling pressure.
As a result, more big bearish candles form.
These candles aren’t forming because people are selling to enter trades, but because the longs are closing out their losing positions.
So, this is how you understand what retail traders are up to:
Just watch for sharp rises and declines.
Whenever you see a sharp rise or decline, assume retail traders are entering trades or close out losing ones. Your task is to figure out which it is, using what I just explained above.
Once you know what’s up, you can use that info to your advantage.
- If tons of traders going long, chances are a retracement is near.
- If tons of traders exiting losing trades, it’s also a sign a retracement is probably close.
Look back at your charts, find some old sharp rises and declines. 9 times out of 10 you’ll see price either consolidate or retrace shortly after. They’ll usually be a small continuation, which is retail traders jumping in, then the retracement or consolidation.
And that’ll be caused by the banks taking profits, because what do the banks need to take profits?
They need thousands of opposing traders – buyers if they’re long, sellers if they’re short.
The retail traders jumping in give them that, that’s why price retraces or consolidates.
Key Fact #2 Dumb Money Can Buy And Sell Freely
When you enter a trade, place a stop loss, or close a trade, do you ever pause to ponder:
- Will my trade execute?
- Can I enter at this price?
- Can I take profits or close out my trade right now?
Chances are, you probably don’t, right?
That’s because you can buy and sell whenever and wherever you want.
But here’s the kicker: The only reason you can buy and sell anytime and at any price is that you don’t trade at a size large enough to impact the market.
Your positions are so minuscule they only require a handful of opposing buyers or sellers.
You never have to think, “Hmm, are there enough sellers available for me to buy here?” That’s because your buy order is so insignificant sellers are always available, regardless of the price. This may not seem like a big deal, but trust me, it’s a massive advantage.
By being able to buy and sell freely, we can get in and out of positions quickly.
If we go long and the price starts to fall, we can exit immediately and avoid a significant loss.
If we were trading a huge, long position, though, that wouldn’t be the case.
We’d have to endure the drop and then wait for the price to retrace.
Because to close a long trade, you need buyers – you’re selling what you bought. If the price is falling, only a small percentage of traders are buying. So, you can’t sell.
You must wait for the price to retrace and then close out your long trade.
On top of that, we don’t need to fret about where to get in.
Our trades are so tiny that we can enter basically anywhere – even if the price is moving in the direction we expect.
Again, that wouldn’t be the case if we were trading colossal positions.
The larger our positions, the more traders (buyers or sellers) we need doing the opposite.
If we want to enter a massive buy trade, we need thousands of opposing sellers.
So, if price is rising, we can’t enter – because no one is selling!
The reason this is so crucial to understand is that while we can buy and sell freely, the smart money and other big players can’t. Yup, they cannot buy and sell whenever and wherever they want. This means they have limitations on what they can and can’t do.
This is how we’re able to figure out how the smart money trade.
These limitations give us rules or conditions on what SM can do and where. By understanding them, we can determine the actions banks have available.
And with that, let’s now jump over and learn how the SM trade!
Smart Money Traders – (Bank Traders/Hedge Fund Traders)
Smart money traders—like those in banks and hedge funds—are definitely the most important group to study in forex.
According to Wikipedia, institutional trading makes up over 65% of daily forex volume.
So, to put it simply: The smart money rules the forex market.
Every reversal, consolidation, and retracement originates from smart money executing one of these three trading actions:
- Placing trades.
- Closing trades.
- Taking profits.
Now, you might think studying smart money and understanding their market strategies seems impossible. But here’s the deal: SM traders must abide by the same rules and conditions the market presents.
For instance: Forex is a zero-sum game.
Being zero-sum means the SM has to make other traders lose to turn a profit.
…No ifs, ands, or buts.
The size of their positions also means smart money needs tons of opposing buyers or sellers to execute market actions.
- For the SM to buy, loads of other traders must be SELLING.
- For the SM to sell, loads of other traders must be BUYING.
So, to sum it up: Smart money traders’ actions and profits depend almost entirely on other traders’ actions—namely, the “dumb money.” And that means we must follow and track the SM to profit, as we can’t move prices; only they can.
But wait, there’s more: You can determine how the SM trades using the info above.
Smart money is bound by the conditions we just mentioned, which limits when and where they can execute market actions.
- The SM can’t place a large buy trade without thousands of sellers.
- The SM can ONLY buy after the price has fallen consistently for quite a while.
So, here’s the secret: To identify when/where the smart money entered a significant buy position, look for a reversal after an extended down-move or downtrend—it’s the SM buying!
How The Smart Money Trade: A Breakdown
The conditions outlined above are important, but the most critical point to understand about how the smart money trade is they 100% control the market.
You name it, the SM started it.
Remember: It takes hundreds of millions to move the exchange rate of a currency. Only the smart money have pockets deep enough to influence market prices. The dumb money can cause major movement during one sided events (sharp rises/decline or news releases)
For the reason: The smart money control the market.
They decide when and where price reverses.
It’s not random, it’s the SM buying and selling.
So, any major reversal or price structure you see….
The smart money are behind it.
Now, another two key facts to understand about how the smart money operate:
- #1 The SM CANNOT buy and sell freely.
- #2 The SM profit by making other traders lose.
Here’s a look at each in more detail…
Key Fact #1: Smart Money CANNOT Buy And Sell Freely
Remember earlier when I explained that “dumb money” can buy and sell wherever and whenever they like? Well, for the smart money traders, that’s not the case… AT ALL!
The SM can ONLY buy or sell when specific conditions are met.
So, when do the smart money buy and sell?
The answer… when the price is moving in the opposite direction!
The smart money can’t just buy and sell whenever they want – their positions require tens of thousands of opposing buyers or sellers. Therefore, the smart money can ONLY buy or sell when the price is moving in the opposite direction of the trades they want to place.
- If the smart money wants to sell, the price must be rising.
- If the smart money wants to buy, the price must be falling.
The above applies to all trading actions – taking profits, closing trades, and, of course, entering trades. All actions require thousands of opposing traders. The smart money takes profits off a buy position by selling, so price must be rising for them to sell into the buyers.
Does that make sense?
Here’s a quick breakdown:
When price is rising, smart money can…
- Take profits from buy positions.
- Close open buy positions.
- Enter new sell positions.
When price is falling, smart money can…
- Take profits from SELL positions.
- Close open sell positions.
- Enter new buy positions.
Now that you know the conditions required for smart money to execute different trading actions, you can use your newfound knowledge to analyze the market.
Look at the chart above… where did the smart money buy or sell here?
See it yet?
Answer: The swing highs and lows!!
The smart money creates the swing highs and lows by placing trades, closing trades, or taking profits. How do I know the smart money formed the highs/lows?
- It takes HUGE money to make the price reverse.
- The smart money can only buy when others are selling and vice versa.
If price is falling, most traders are selling – hence why it’s falling. For the market to now reverse and begin rising, a huge amount of money (force) must come in.
Who can provide that force?
There’s only one answer…
The smart money!
Only smart money traders have the funds required to cause price to change direction. And they can only cause a reversal when thousands of opposing traders are available – i.e., when price is moving in the opposite direction to which they want price to move.
That’s just how the smart money operates in forex.
Here’s the image again, but with the actions marked…
With hindsight, knowing which decisions create each swing high/low is clear. In realtime, however, you wouldn’t know (for sure) whether the smart money are entering trades, taking profits, or closing trades to form these swing highs/lows.
However, here’s the trick…
You can asses the probabilities using game theory.
If a new significant down-move has just started, like you see above, and price has fallen sharply, you know the banks will soon take profits.
If price now moves higher, chances are it’s a retracement.
The smart money will probably take profits due to the steep move lower – wouldn’t you take profits after price moves heavily in your favour?
That information can now help you better tackle the situation.
Now you know the rise probably won’t last too long. So, any technical points – like supply and demand zones – that formed during the decline are points where price could reverse.
You can now use these to look for trade entries, knowing price will probably soon reverse.
Do you see how this helps then?
How understanding the banks limitations can help us predict the market?
While we don’t know what decision the smart money will make or where, we know what decisions they can make and gauge the probabilities using the market. That increases our understanding of the situation, allowing us to make better descions ourselves.
Key Fact #2: Smart Money Profit By Making Dumb Money Lose
The second point to grasp about how the smart money operates: They can only generate profits when other traders lose money. But why?
Because: Forex is a zero-sum game.
What the heck is that?
A zero-sum game is one where the participants’ gains or losses are precisely balanced by the losses or gains of the other participants involved.
In other words, the total amount of resources (money, in our case) in the game remains constant, and any gain by one player must be offset by an equal loss for another player. For instance, in a poker game with a fixed pot, one player’s winnings come at the expense of other players’ losses.
The total amount of money in the game stays the same, just redistributed among the players. In this case, the sum of all the players’ gains and losses is zero, making it a zero-sum game.
Forex being zero-sum means the only way to generate profits is by taking it from other traders when they lose money, i.e., when they close at a loss.
So, the #1 aim of the smart money…
To inflict the maximum amount of financial pain on the highest number of traders as possible. The more profits the smart money wants, the more traders who must lose.
But wait, here’s the good part…
By knowing the smart money must make traders lose to generate profits helps; you can start to understand why the smart money must create specific conditions and the effect those conditions have on retail traders.
If price rises continually without any significant pauses breaking up the action – retracements, consolidations – masses of dumb money traders will enter long.
For the smart money, that’s a MAJOR problem. Why?
Because: Forex is a zero-sum game – the losers pay the winners.
If swathes of dumb money traders jump in after the smart money have already bought, how can the smart money keep making money?
Answer: They can’t – barely any losers exist!
The smart money must cause confusion to make the dumb money trade the other way. And how can they create confusion?
Using one of three different price structures:
Any of those 3 structures will make the dumb money second-guess the current up-trend, causing many to enter short or close their open longs.
And that’s what happens in our example…
After price climbs higher, we see a serious retracement!
Price dips waaay down into the previous swing. This forces those poor, clueless longs to close up shop and lose some serious dough. Now, the market’s looking extreamly bearish, and those gullible traders – bless their hearts – jump in and go short.
And guess what?
These fresh shorts are will fuel the smart money’s profits as the reverse the retracement and ride that sweet, sweet wave back up!
Here’s how it happens…
The SM buys from the shorts, causing price to reverse.
Now, the short traders start losing money and exit their trades at a loss, causing price to rise further – remember: you close a losing short by buying back what you sold.
So, what happens as the price rises?
The SM profits EXPLODE!
The buying pressure generated from the shorts liquidating pushes the price higher, which, in turn, skyrockets the profits of the smart money traders’ long trades.
We then see the three phases:
- Imbalance – SM buys to reverse the price.
- Liquidation – Shorts closing.
- Awareness – Burned shorts now going long.
Once those three phases complete, most dumb money traders will be long again. So, the smart money triggers another large retracement, consolidation, or reversal to shake them out and make them enter short again.
See how crucial it is to understand that the SM relies on other traders to profit?
The SM CAN’T profit when most other traders are winning.
Therefore: Price CAN’T rise or fall consistently – consolidations and retracements must form for the smart money to shake traders out and create new losers to profit from.