What Causes Markets to Change Direction?

When looking at the markets, many traders look at lagging indicators for a signal that the market is changing in direction or to confirm that the main thrust of the market will persist. These conventional indicators quickly lose their edge as the institutions (mainly through algorithms) identify these common patterns and take action to move the market to nullify, or take the other side, of these trades causing those traders to lose.

In order for a trader to maintain profitability, she must have an edge. In the futures market, this becomes even more critical as leverage and the fact that trading futures is a net zero sum game makes it very challenging to maintain an edge if a trader is using the same strategies as everyone else.

Dynamics of the Market

To make this concept simple, let’s think about two immutable laws of market dynamics.

Buy and Sell Transactions

First, in any buying and selling transaction, there have to be two parties in order for it to materialize. A buyer will buy based on a perception of value, but will need to find a seller that has the opposite view of the exact same item or financial instrument. This could be for a futures contract, a stock or even a house for that matter.

Supply and Demand

The next factor is the concept of supply (large amounts of unfilled sell orders) and demand (large amounts of unfilled buy orders). When sellers are largely depleted, demand will take over and change the trajectory of the market. This works exactly the same on the buy side of this  equation.

Another way to look at this concept is through the law of inertia. Inertia is the tendency of an object to stay in motion, which in the markets is referred to as a trend or momentum. Yes, trends tend to persist, just like objects in motion. However, the momentum will slow and reverse when it is met with an unbalanced force, or as Galileo discovered, it was friction that caused objects to change direction. In the markets, the reason markets turn is because of the shift in the Supply and demand equation.

Put another way, an uptrend will persist until all the buy orders are filled and an overwhelming amount of unfilled sell orders are found. It is impossible for the market to move higher unless all the sell orders can be matched.

Understanding this concept helps traders understand where to buy or sell, but also, and more importantly, helps traders identify how far the market can travel in the opposite direction so they can realize gains.

In one of my recent spotlight sessions we identified a daily demand zone (unfilled buy orders) in the Platinum futures market.

In the picture below, we see that price fell sharply into that demand zone creating a big distance between the entry and the new supply. Inertia is now in play here. If the unfilled buy orders (demand zone) will turn prices higher, how high will they go? They will continue higher until they meet a large amount of  fresh sell orders, would be the correct answer.

As we can see, this particular trade worked because the Platinum rallied off the demand and traveled back up to the supply before turning down. In fact, it turned down at a lower supply area, created new demand and kept moving higher before meeting more sellers.

Not all trades will work, as we all know. That’s because, unlike physics, the markets aren’t an exact science. The point here is that if we apply science versus emotion we can increase the probabilities of success. And yes, we can start anticipating market turns before they happen with a high degree of accuracy using simple laws of physics.

Please don’t misinterpret this as an indication that trading is easy. It’s actually quite challenging if you don’t have the right rules and the self-control to follow them, but it does help to keep it as simple as following the basic laws of inertia using supply and demand.

Until next time, I hope everyone has a great Holiday Season.