One phenomenon in the finance and trading industry is the flood of experts and analysts coming out from all corners of the internet with explanations on why the market moves occurred in the hindsight.” The market reacts to this news.”; “The market reacts to this technical level.”; “The market is doing this and that.”. Although most of the opinions differ, what doesn’t change are basics in the order flow and supply and demand dynamics. Understanding these fundamental principles of the market movements is something every trader should be aware of as this can highly improve your trading. In this article, we are going to explain the basics and then show you how you can turn the theory into the action and make some profits.
What is the market and why it moves?
The market is an advertising mechanism and all it does is advertising prices for traders and market participants.
The only purpose of the market is to facilitate trade and seek value.
Because of that, markets are constantly moving from the balance to imbalance and vice versa. Balance areas are often called ranged and imbalance areas are called trends.
The common misconception among traders is that when the market moves strongly in one direction, there were more buyers than sellers.
This is not true simply because in the market for every buyer there has to be a seller and vice versa. When markets are going up, it is not because there are no more buyers than sellers, but because buyers are more aggressive than sellers.
This might seem like a small detail but it plays a crucial role in understanding big moves in the market.
All of this is part of the Auction Market Theory and even though Auction Market Theory gives a great explanation of why markets are moving, it lacks an explanation of the microstructure and what causes these movements.
Volume, Liquidity and Volatility
Now as we know that everything market does is advertise prices and moving from balance to imbalance and vice versa.
We can take a look and understand how these things actually happen.
Volume, liquidity and volatility are crucial components every trader has to understand to grasp why markets are moving, so let’s take a look at them.
Volume represents the number of finalized executions. Although Forex is OTC (over-the-counter) market and doesn’t display volumes, all we need to know is that by volume, we mean all the orders that were actually finalized at the market. High volume = high finalized orders are what causes markets to move.
For those who are curious, you can see a footprint chart of EUR/USD (futures contract) with a finalized executions on Bid and Ask. Prices at the left represent sellers which hit the bid, and prices on the right represent buyers which lifted the offer.
All of these are finalized executions.
Resting orders surrounding the price are called liquidity. These are the advertisements in the market, as orders resting at order books.
Even though we cannot see the depth of the market while trading Forex, very often the prices advertised on DOM are not genuine as big players try to mislead retail traders to the opposite direction so they can use their liquidity to fill their own orders (a term called spoofing).
Example of trading DOM showing liquidity.
Every instrument has different liquidity, which dictates how much each market moves. Highly liquid markets will usually have a harder time to move over markets with low liquidity.
Volatility measures the amount of which the price fluctuates over a given period. To not overcomplicate things, high volatility means big markets movement. Low volatility means markets staying in range.
What is the relationship between these three?
Low volume + high liqudity = low volatility
A lot of orders sitting at the order book but there is no interest to execute them = markets not moving.
High volume + low liquidity = high volatility
Aggressive participants entering the market with not a strong counterparty at the order book = rapid market movements.
Low volume + low liqudity = moderate volatility
High volume + high liqudity = moderate volatility
Agreement on both sides = markets not moving.
How can we profit on this?
As we described different market conditions, which of these will be the easiest ones to make money from? Obviously, the one when the market actually moves.
Because of that, we are looking at occurrences with a significant supply and demand imbalance due to the change in the order books i.e. aggressive buyers/sellers stepping in and clearing the order book causing a significant movement in the market.
When these aggressive moves happen in the market, the market quite often moves inefficiently leaving the so-called liquidity gaps behind the move.
We qualify liquidity gaps as strong momentum candles which broke the structure of the market after the balance state.
As you can see on the chart of Crude Oil above, we can also see the volume profile which displays a significant lack of the volumes on the move down (low volume node).
What is more important is the selling opportunity which occurred once the price filled the liquidity gap.
One last thing you might be wondering is, why the price bounced once it retraced back to the origin of the move?
Big market players who caused these moves have to be careful because of the fact they can occur significant slippage or can get easily front run.
They need these areas of consolidation because these are the places where buyers and sellers meet and there is a lot of liquidity in the market.
Even though they have favourable conditions, they still cannot reveal their size in the order book simply because they would easily get front run by other players.
That’s why they have to stack their orders into these levels multiple times to fill their positions. That is why market often bounces from these areas as in the example of Crude Oil – there were still sell orders left in the origin of the move.
We look for areas of consolidation where the market left in a strong manner leaving a liquidity gap. As big players usually trade in the direction of long term fundamentals, higher timeframes are going to be more accurate and can offer a higher strike rate. That being said, the price is fractal so you can find liquidity gaps with supply and demand imbalances on all timeframes.
These areas of supply and demand have often unfilled orders waiting for the price to revisit and fill.
We hope you liked the article and hopefully, we’ve shed some light on how supply and demand in the market works and what causes the movements in the market. Knowing these things can give traders a significant edge to their strategy.
But as with everything in the market, nothing is for granted. Knowing this, always use the proper risk management and as always, trade safe!