Use Market Mechanics to Your Advantage
January 18, 2008
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John Forman - The Essentials of Trading author
This is an article I wrote for Trading Markets that I thought my own readers would also enjoy as well.
The markets will tell you where they want to go, if you let them. What it comes down to is understanding the market mechanism which underlies price moment. When you operate with that in mind you can see how it plays out in determining the course of price action and use it to identify the likely course of action.
So what is this market mechanism? Well, it’s no secret. It’s just something most traders don’t give much thought to, even though they are a part of it. The markets are facilitators of financial transactions. Some involve stocks, some futures, some forex, but all operate with one primary objective - to create the largest amount of transaction volume possible. The exchanges are motivated to do this for the fees they receive and the market markets do it so they can make the bid/offer spread as frequently as possible. And since it behooves them to have liquid markets where they can readily transaction business, all other market participants support this structure, allowing the exchanges and market makers their profits.
Now, how do the markets create the largest possible transaction flow? By having prices at the levels which most participants at a given point in time agree to as value. That is to say, when a buyer and seller come together they have agreed to the value of the thing they are exchanging, even if it’s just for a split second. The market’s interest in maximizing volume is to ensure that prices at any given time best reflect the value perspectives of both buyers and sellers. As a result, price will always move to find the levels at which the most volume because the market makers, in response to the market environment, will move them there.
This continuous pursuit of value by the market makers is what we see playing out on the charts. If we know what to look for we can identify the levels at which the market most found that value - meaning the market spent more time at those levels and/or did more volume there. There are two “high value” areas on the chart below.
At the left of the chart we can see a market searching for value. It is moving rapidly in one direction. Then it finds that value and spends about 10 periods there. Something happens to change trader’s perceptions eventually and the market goes back into a period of trying to find value again. Notice that twice it runs through the first “value area” along the way before settling at a slighly higher value. That is what markets do - move from periods of stable value to ones where it’s trying to find where the value is and back. It shows up on any chart in all timeframes and markets.
Candlestick and bar charts don’t always make it easy to really spot the finer points of where the market has established value, though. For that we can turn to a different style of charting based on the distribution of prices during a time period. This is sometimes called Market Profile®. Others call it volume at price, TPO charting, and other variations. The basic idea in all cases is what you see at right below.
The graphic above shows 1 day’s worth of trading in two fashions. At left we see 30 minute bars in the classic style. At right we see the distrubtion chart which shows, for lack of a better description, how often the market passed through a certain price level. It’s kind of like crunching the bar chart together. Count the number of bars at left which included the 1400 level, then notice that it matches the number of letters you can see across at the 1400 level on the distribution chart. The thicker the distribution at any given price level, the more value was found there by market participants. The thinner the distribution, the less value.
Now, knowing that the market makers are going to try to move price to where the buyers and sellers most percieve the value to be, doesn’t it make sense that when the market is in a transitional phase and is trying to find a new equilibrium they will see former value area as likely areas for that? It’s like when you find yourself in an uncomfortable position you go back to what you remember as being a comfortable one. In that way, areas were there was a lot of value before become attractors - targets.
The application of these value areas and rejected levels is relatively straightforward. One of the most useful is in determining the potential of a given trade. When you can look at a graph and see where the market is likely to go, you can better identify trades likely to produce the type of reward/risk profiles for which you are looking.
Let’s use this chart to shape an example.
Each one of the distributions above (S&P 500 index) represent one day’s trading. If a trader were looking at things on or after the second day with an idea of selling the market, the high count part of the first day’s distribution at 1466 becomes a very clear target. If the market starts moving lower, it would be very likely to at least approach that level. It’s an area where the market spent a lot of time the first day (established value), therefore will become an attractor for future price movements.
Of course that doesn’t mean the market will necessarily stop right there, as things are rarely that precise. Sometimes it will nail it on the button, but other times it will come up a bit short and others it will go further (maybe even much further). But that is part of the value discovery process.
Naturally, there is a bit more to it, but this provides a good start point. If nothing else, it should give you a different perspective on the idea of support and resistance.
If you would like to learn more about how you can identify price targets in this fashion, you’ll want to take a look at the course I prepared on the subject. Click here for more information
® Market Profile is a registered trademark of the Chicago Board of Trade.
Here are some other posts which might interest you:
Actually, the transaction price is at the center of a disagreement about value. The two sides never agree on the value of the item - if they did, they would be indifferent to the exchange!
Buyers buy because they think (even if only at the moment of transaction) that the item is worth more than the money they’re spending.
Sellers sell because they think (even if only at the moment of transaction) that the item is worth less than the money they’re receiving.
“Special circumstances” like a margin call will influence the mental calculation made by sellers, i.e., they may think it’s worth more most of the time, but their immediate need for the money makes them desperate enough to think it worth less AT THIS MOMENT.
This differential in value perception, and the opportunity to arbitrage it, keeps market makers in business and generally greases the system. It’s also the genesis of some of the neater tick-based sentiment indicators, such as how many transactions are hitting the bid vs hitting the offer.
If transactions are hitting the bids, then the sellers think it’s worth a lot less than the money, while the buyers think it’s worth only a little bit more than the money. Reverse that for the transactions hitting the offers. That’s a powerful sentiment tool.
Keep in mind that price is not an agreement, but a disagreement, over value, and that will add a little more color to the rest of the piece.
Bill - Thanks for presenting your thoughts.
I totally understand where you’re coming from in terms of price being a disagreement on value. The problem I have with that view is the scope is too narrow. It doesn’t take into account an array of things which play out in the market.
You touched on the subject of a margin call, which alters the participant’s perception of value at a given time. The need to liquidate to square things up with his broker alters the equation. That’s just one example, though. There are a great many situations in which a trader can have a particular view on the markets, but has other ancillary things disrupting his perception of value (for better or worse). Wanting to get rid of the stress of a difficult position is one. Needing the cash for another position is another. I’m sure you could come up with loads of them.
There’s also the question of timeframe. Traders operate on lots of them and what looks good in one timeframe may not in another, creating different value perceptions.
And of course there is a big difference between selling to close a position and selling to enter a short, or buying to exit a short and buying to go long. They all involve different value judgements.
Oh, and we also have to toss into the mix non-speculative activity in the markets, meaning those who buy and/or sell for business needs. Value for them is generally unrelated at all to the direction price will go in the future. It could be protection against potential loss (hedging), or aquiring capital (issuance), or any number of other things.
The point I’m trying to make is that at a given point in time - and that’s all we’re talking about here as things can certainly change - the buyer and seller come to agreement on value when they execute a trade. It’s just like any other business transaction. Of course it’s all based on perceptions, which certainly can be quite wrong, but that is something which factors into future value determinations.
Hope that makes sense.