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The Psychology of Price Movement
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The most important thing to realize is that the market works in a way that permits only a handful of traders to win and the majority to lose. Bruce Covner, one of world's biggest traders in the currency and futures market, said in his interview to Jack Schwagger: "One of the traders I know does very well by trying to figure out how the stock market can hurt the most traders". This principle serves as a foundation for our entire tape reading concept.
Why does the price of a stock move?
This is the general understanding that is required by a trader. He can't plan his actions without it. Let's try to analyze what force moves the price of a stock and then further our understanding of how to apply it to real trading.
We usually say that the buyers move the price up and the sellers move it down. It seems obvious but many still ask the following question:
Since every trade is buy and sell at the same time, why does it affect the price?
The main distinction is that each price level has a certain amount of POTENTIAL buyers and sellers. Below, each price level is color coded to differentiate the visual strength in the stock both on the bid and ask side. Each market participant is a potential buyer or seller. Further, each market participant is required to be on both sides of the trade to ensure liquidity. This requirement excludes ECN participation.
While each trade that already took place really had one seller and one buyer, there are also buyers and sellers that evaluate the situation and make their decisions. If their ratio is not balanced, it creates the base for price movement. If the buyers are active, they are hitting the ask, bidding a stock up and chasing it higher. In this case, we would expect the stock to move higher. If the buyers are passive, they are sitting on the bid, willing to buy only if the selling is not too active and ready to drop the bid lower if selling increases. This type of buying would most likely not cause the stock to move higher.
The same applies for the converse case of selling. If active selling came about where sellers were hitting the bid sizes while lowering their ask price, the stock would most likely move lower. Therefore, price movement is a matter of confidence and beliefs in different market participants that determines the supply and demand ratio.
Obviously stocks do not go straight up or straight down. Therefore, a trader needs to learn how to determine at what points, the stock will reverse in direction in order to capitalize on such an event either with an entry or an exit.
Suppose a stock price started to rise because the buyers strongly believe it represents good value at the current level and should trade higher. Sellers consequently are willing to lift their offers because they are convinced by increase in buying pace that the current price level is too low and the stock can be sold higher.
At some point we can glimpse how this set of beliefs changes. The buyers start to doubt that a stock still has a significant upside and want to take their profit. The sellers doubt they can sell a stock higher and start to increase selling pressure. In the picture below, on the right side of the Level 2 screen, you can see the Time and Sales Ticker. The green coded trades were buys and the red coded sells. As you can see in this example, the stock received enough buying to take the stock from it's day's low of 16 1/8 to the high of 18. You are able to see 7 trades at 18 before numerous sells of 17 15/16 made the stock downtick to the current spread of 17 7/8 x 17 15/16. This represents the idea of how buying faded, the stock started to get selling and the lack of aggressive buyers allowed the stock to downtick. As a result, the stock is showing a possible turn.
Traders are actually in this sense looking for the point where beliefs about the stock's future change. As in this case, the same applies when we are trying to determine the top. In this example, a trader can do one of many things. They can sell a long position if they feel that 18 will not be broken. They can initiate a short position if they feel 18 will not be broken.They could also hold a long position if they felt that this reversal was minimal and that it would break 18 where they could sell at a higher level. You can see that in this case, the belief conflict is whether or not the stock will break 18.
When a trader finds certain events that repeat over time to a reasonable enough degree, they form patterns in their trading system to capitalize on their belief system. Patterns work because they are based on observations about where beliefs of the market participants usually change, what events trigger those changes and what signs help spot those points. Supply and demand is being affected by different opinions and this is the main factor that moves the price depending on which side is stronger at that given price level. Spotting these points of reversal and trend continuation can be found in the principles of tape reading.
Main principles of tape reading.
The most important rule to remember is that nothing is certain in the stock market. We have yet to see a system that works 100% of the time in active trading. Any set of rules and principles simply gives you higher probabilities for success in the outcome of that trade. Those times when the trading and belief system does not allow for profit, a strict stop loss regiment is employed.
Tape Reading is one of the oldest methods of market movement interpretation. Like any other methods applied by market players, it's intended to show "what's behind the ticker". There is no tape itself anymore. It has been replaced by a scrolling Times Of Sales Window and Electronic Tickers. But the term, and more importantly, the principles are alive and are as helpful as ever. They are based on aspects that never change. These are human psychology and major accumulation/distribution rules. The following principles will explain to you some of the more common events that can be seen by following the tape itself.
1. Price advance with steady increasing volume indicates continuing upward momentum.
2. Slowing pace of buying with decreasing volume indicates that the top of this stage of movement is near.
3. A relatively big volume increase on the price advance with shallow volume on the reaction indicates a continuing uptrend.
4. Big buying volume without price changing indicates distribution and means resistance level.
4a. Big selling volume without price changing indicates accumulation and means support level.
5. Slow steady movement upward with consistent volume indicates the so called "good buying" and means continuing upward momentum.
6. An acceleration in the price advancing, almost vertical movement, is usually not sustained and indicates the end of this stage of the move (euphoric stage).
7. After an initial movement in the stock, it settles into a defined trading range. Then it oscillates within this trading range for an uncertain period of time. Finally the stock breaks support or resistance of that trading range moving further in that direction.
a. Scalping within the range.
1. Slow accumulation
2. Bottom fishing
3. Pattern reversals
4. Trend Continuation
By Vad Graifer