Tuesday, April 29, 2014

Price Action Basics

Hi everybody! Let’s continue our study in price action and market logic.

How do you think, what is the main goal of the marketplace? Some would say – market brings together supply and demand, and that would be right answer, but it would be too abstract.

Liquidity – what trader needs to know?

The goal of the marketplace is not just to gather buyers and sellers and give them opportunity to trade, but to facilitate trading. What does it mean – to facilitate? It means that big market participants that mostly benefit from liquidity, will be interested in active trading from all types of traders.

The more traders are involved, the better execution large speculator or commercial trader will have.

Exchanges, for example, hire special companies, that are called «market makers» and pay them salary for keeping two-sided quotes – therefore every investor will be sure that he will be able to get a fill for his position.

But even though, two-sided liquidity providers are unable to keep market in a balanced state when there is some aggressiveness in the market and liquidity is not very high.

Trends often occur when there are not enough traders involved and market has to advertise more and more to attract liquidity. So, big market participants are often not interested in trends, they would rather prefer balanced state of market to have opportunity to slowly accumulate their positions. It’s tough job – to accumulate position on the rising market.

But we as traders are interested in trends, aren’t we? Of course, idea of a trend is different for day-trader and for position trader. Let’s now talk about short-term perspective.

See the picture below – how do you think, where liquidity can come to the market, in point A, B or C?

Obviously, points A and B are extremes of the bracket, and there are always traders that will try to fade extremes, as well as traders that will try to play breakouts.

In point «C» there are not too many traders involved – they don’t know how to calculate the risk and where to place their stops, that’s why I can call this area «no mans’ land» and areas at the extremes «hot spots of liquidity»

If market is trading without significant support from other timeframes, it will tend to go from one extreme to another, yet it’s tough to calculate risk at the extremes, because you don’t know who will win in short-term time perspective – buyers and sellers, buyers can create a breakout, collect stops of sellers, then market will go lower, or sellers can drive the market down and buyers will liquidate.

So, when the crowd is there, don’t expect that price action will be predictable and smooth.

In my own trading, if I see that market conditions are balanced, I rather try to work near «no man’s lands» in the direction to «hot spots» where I cover my positions.

Key here is aggressiveness – if market is aggressive and volatile and liquidity is not enough, it will tend to reach extremes – market needs liquidity, after all it is an auction which goal is to facilitate trading. Liquidity is located near hot spots – I exit there, I don’t know who will win and I even don’t want to predict it.

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