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How the Markets Work?

You might be wondering why it’s important to know about how the markets really work. Well, it’s extremely important and we believe that the majority of traders end up losing their money because they don’t really know how markets work. They risk their money without the knowledge of these basics that govern the price movement of all markets.

One of the most popular fallacies about the markets is the statement which says that the price is going up because there are more buyers than sellers. This is completely false because for every buyer there is a seller and vice-versa. In the auction of financial markets, there is never such situation where there are more buyers or more sellers.

Then, what makes the price to move up and down?

To give an answer to this important question, let’s look at two different cases. On the top chart, we have the price of Gold going down and on the bottom chart, we have the USD/JPY exchange rate going up.

 

What happens in each situation? What makes the price go up on USD/JPY and going down on Gold?

If your answer is that the price is going up because there are more buyers than seller and the prices go down because there are more sellers than buyers than that’s not entirely correct. The markets just don’t work like that. These are the most popular misconceptions about how the markets work.

If you think about it, it doesn’t actually make any sense. For example, you see the price going up and you want to buy because you believe that it will continue going higher so you can later sell with a profit. Now, if the statement about more buyers than sellers would be true, you could be in a situation when you couldn’t buy because there would be fewer sellers than buyers.

In other words, there will be nobody to buy from you just came too late as there are no sellers left to take the other side of your trade. The same holds true if you want to sell because there would be nobody to sell to.

Of course, the market doesn’t work like this, nowadays you can buy or sell anytime the market is open and you can do so at any price.

The reality of the markets and the process behind what drives the price up and down is as follows:

  • The price is going UP when buyers are more aggressive than sellers.
  • The price is going DOWN when sellers are more aggressive than buyers.

What do we mean by being more aggressive?

It’s simple, aggressive buyer or sellers use a market order to open trades which means that it consumes liquidity. There are two main types of orders in any financial market, it doesn’t matter if we’re talking about Forex, stocks or futures it works the same in any financial market. These two main order types are:

  1. Market orders
  2. Limit orders. A limit order will be the one who provides liquidity.

There are also some subtypes of these orders, but at the moment we do not need to know about them.

Supply and Demand Equation

 

 

The total amount of an instrument which sellers want to sell represent the supply side of the market.

The total amount of an instrument which buyers want to buy represent the demand side of the market.

As we’ve previously established, the market moves in the direction where the market players are more aggressive. This is what causes the demand being higher than the supply side. If buyers are more aggressive than sellers the market will move up, and inversely, if sellers are more aggressive than buyers the market will move down. This is what causes the supply being greater than the demand side.

Contrary to the popular believe, the market will continue to move higher until there are no more willing buyers to drive the market up. In other words the market will go up until the demand side drys out.

Inversely, the market will continue to move lower until there are no more willing sellers to drive the market down. In other words the market will go down until the supply side drys out.

 

How to Practically use Supply and Demand

By now you probably ask yourself: How can I use these market principles?

Well, you now know that the market is moved by supply/demand imbalance that is driven by aggressive traders using market orders. These aggressive traders need to clear all the limit orders to move the market. With this information, you can now understand what happens when the market makes a new low and reverse or what happens when the market makes a new high and then reverses.

You can also predict where it’s most likely to have supply/demand imbalances. In other words, as an order flow trader, you now should think along the following line: at what price you can expect a massive limit order to be placed which will stop aggressive buying/selling pressure.

Trading with an order flow mindset means that you now need to put together a puzzle where you put small pieces of information to build a bigger understanding of what drives the market.

Let’s look at an example.

In this example, we’re going to focus on the market scenario of what happens when the market makes a new low and then reverse. What happens in this situation from a supply and demand point of view?

In the chart below, the Gold price is going down. You should now understand what needs to happen in order for the market to stop and reverse. What needs to happen between the supply side – the aggressive traders in this case – and the demand side, which is represented by passive traders?

Let’s first analyze the Gold chart; the price is going down after it created a double top pattern. The sell-off is now visible to all market participants. Now, many aggressive sellers will be selling because the price is going down very quickly and they believe it will continue trading down.

Let’s continue.

Other indicators based traders will join the sell off later because of the lagging nature of these indicators will trigger a trade well after a move is put in motion. This confirms that there will likely be more aggressive traders pushing the market down.

But are these aggressive sellers?

Most likely not, because these aggressive sellers are most likely small retail traders which are wrong almost all the time. We have learned that for every sell order must be a buy order, most likely the counterparty of these sellers are the smart money or the big money institutions, which uses limit orders to get in the market and which absorb the liquidity.

For example, let’s say that after we broke below previous low 500 buy limit contract show up while the aggressive traders will sell 200 contracts being able to clear 200 buy limits, but 300 more are yet to be paired. Since there are no more aggressive traders to open new positions, it means they are not able to absorb all the buy limit orders.

The price stops because sellers are exhausted as everyone who wanted to sell already sold and there is no one left to continue to drive the price lower, the supply side is drying out. Meanwhile, aggressive buyers are now stepping into the market which drives the price higher and subsequently this move will attract more buyers to buy increasing the demand side.

The buyers are now in control of the market as the demand side is more aggressive. Now, everyone who previously sold expecting lower prices has now his position in jeopardy. Many of the previous sellers have their stop loss placed above the double top pattern because that’s what technical analysis text book says. All the collective stop loss above the market is now considered to be a pool of liquidity, and since we’ve learned that for every sell order there must be matching buy orders, these pools of liquidity will attract those buyers to unload their position.

Going further, once these stop orders get triggered they will become market orders which have the potential to trigger a price cascade that will self-reinforce the price movement.

These are the basics of how the supply and demand work in the financial market and is the reason behind any price movement.

 

Summary

The interaction between market orders and limit orders is what moves the price of any market. The price moves in relation to the number of market orders versus the available limit orders. This may sound really boring and maybe even confusing, but be patient because the more you’ll work to think as on order flow trader the better you’ll understand the markets. Market price moves because of the supply and demand imbalances… supply and demand imbalances change because of the buyers/sellers aggressiveness.

Put it in simple terms, the price of any market moves because of the supply/demand imbalances and because of the buyers/sellers aggressiveness.

Thank you for reading!

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About Louie Lewis

Louie Lewis
Successful forex trading starts with you first. Then comes the actual strategies and techniques. I have been involved with forex and forex trading for a few years now. It is a wonderful way to build wealth. The learning never stops and I want to help others along their journey into this wonderful market of opportunity.

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