In their quest to make money from the markets, few traders stop to think and ask themselves a very basic question about Price Action “Why does price move?”
We accept that most of the time, prices action develops in a relatively orderly manner. Traders tend not to worry about why that is. It just is.
Did you ever stop to think about:
- Why prices don’t simply remain unchanged?
- In a given market, why must price move at all?
- For that matter, when it does move, why doesn’t it move just randomly?
How is it we don’t see the Crude trade at 49.99 one moment, 70.89 the next, and 5.00 just after that?
Many explain price action as a result of supply and demand, but supply and demand for what, exactly? A crude futures trader is trading futures contracts and not crude itself. Sure, if you hold the contract ‘till expiry, you are going to end up taking delivery of the actual oil. Most traders don’t do that. The contracts we trade are created and eliminated as people trade with each other. In other words, the supply is effectively infinite for futures. So how does an imbalance of supply and demand cause movements in price when supply is infinite? It doesn’t. With stocks, there are a limited number of shares issued. Limited resources theoretically becomes a factor. Most of the time though, scarcity in shares is simply not a factor behind price action and is absolutely not the cause of each individual change in price. Can you imagine almost running out of shares and then suddenly there being too many each tick up and down?
There is a theory that the price rises because there are more buyers than sellers, but that simply isn’t practical. The markets where we trade have one purpose and that’s to match buyers with sellers and take a fee off us for doing so. Each trade requires that both buyer and seller be present. As each transaction is both a buy and a sell; the number of contracts that traders buy and sell remains the same.
So what magical power behind price action is causing prices to rise or fall the way they do? Why do separate markets move at different paces? As a case in point, why does Gold move with greater volatility, over a greater range of prices each day than the US Treasuries?
Behind Price Action is “Liquidity”
Picture the market as if it were a tall building with no stairs. As prices rise, they break through the ceiling above to the next level. As prices fall they push down through the floor. Wherever we are in a market there is a ceiling above and below, a floor. These floors and ceilings are formed by limit orders. Also known as bids and offers and also what people refer to as liquidity. Each market is different. Some of these barriers are thinner (as with DAX, Crude or Gold). Markets such as the US Treasuries, Eurostoxx 50 and US Equity indices have much thicker floors and ceilings.
The job of pushing through those floors and ceilings is performed by market orders. They consume the liquidity, effectively leaving the barriers thinner. Market orders eat away at the liquidity until there is none left at that level. The next market order then starts to consume the liquidity at the next level and at that point, price has moved. This is the cause of price action. Level by level up or down the building, price progresses by market orders consuming liquidity or breaking through the floors and ceilings.
So what Exactly is “Price”?
It is important to note that when we look at the price on a chart, what we are seeing is the last traded price. Price action is historical, even what people consider to be “current price”. It’s really just “last price traded”. It is not the same price we will buy or sell at next. The price at which we buy or sell at next will be the inside bid or the inside offer price.
It should be clear that at any time, the market has two prices, the price we can sell at and a different price we can buy at. This is also going to be impacted by how keen we are to buy or sell. Should we buy at market (consuming seller liquidity) or join the bids (providing buyer liquidity)? The former guarantees we buy immediately. The latter means we have to wait our turn in the queue and possibly miss out on a trade.
Bids and Offers, buyer and seller liquidity (Jigsaw Depth & Sales)
In the above image we can see:
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