A Breakdown of Markets and Human Nature

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While it’s quite easy to place a trade and watch how it trades in profit or loss after a few minutes, not many traders truly understand the markets.

Markets are very complex, yet quite simple at the same time. Once you understand how markets operate at a truly fundamental level, it will completely change the way you look at prices in the future.

Here is a detailed breakdown of markets, human nature, and emotions that impact prices.

Markets as a Battleground Between Buyers and Sellers

When you look at a financial chart, what do you see? If you’re just getting started with trading, chances are you’ll see a bunch of random bars and candlesticks spread all over your screen.

If you’re an intermediate trader who went through a few online trading courses, you’ll likely be able to spot trendlines, support and resistance levels, or even some candlestick patterns, such as dojis and engulfing patterns.

However, if you ask an experienced trader what he sees on a chart, you’ll likely get a completely different answer: Professional traders see charts as a visual representation of buying and selling power in the markets.

In other words, professional traders see charts as a battleground between buyers and sellers. When sellers have the upper hand, the price will be in a downtrend. And when buyers have control, the price will be in an uptrend. Buyers represent demand in the market, and sellers represent supply. Whenever demand exceeds supply, the price of a freely traded good will go up. The opposite is true when supply exceeds demand – The price will go down.

While professional traders pay close attention to technical levels, mainly to determine entry and exit points (fundamentals are used for direction!), they know that a chart is nothing more than a visual representation of the demand and supply, of buyers and sellers.

That’s also why candlestick patterns work. They show graphically how the battle between buyers and sellers unfolds. Therefore, a doji (a candlestick where the opening and closing prices are the same) shows that neither buyers nor sellers have currently control in the markets.

On the other hand, a bullish engulfing pattern (a candlestick that engulfs multiple previous candlesticks) shows that buyers have the upper hand as they managed to form a strong bullish candlestick relative to previous trading periods.

So, how can traders take advantage and reliably measure the power of buyers and sellers in the markets? Let’s find out in the following lines.

How are Prices Formed

As most of you know, prices in the financial markets usually come with a spread, i.e. a buying price and a selling price, also known as bid/ask price. For example, a stock can trade at $50.50/75, which means that the spread is 25 cents. In the forex market, the GBP/USD pair could trade at 1.3025/27, which is a spread of 2 pips. The market maker (broker) is willing to sell pounds at $1.3027 and to buy pounds at 1.3025. The difference between the buying and selling prices represents the profit margin of the market maker.

But, how are prices actually formed in the market? What does it mean that the pound is trading at 1.3025/27, and how do prices move up and down on a very fundamental level?

Every price is an agreement between a buyer and a seller. If a seller is willing to sell at 1.3027 and a buyer is willing to buy at 1.3025, this creates the current market price of 1.3025/1.3027.

However, there is still no transaction happening here. In order for a transaction to occur, both the bid and ask prices (the buyer and the seller) have to agree on a specific price level.

Let’s say the UK publishes a series of weak market reports. Now, sellers want to sell their pounds quickly in order to avoid larger losses and lower prices in the future. To do so, they have to drop their selling price to be able to attract buyers. However, buyers know that the market reports published by the UK came in weaker than expected, so they’re not willing to pay higher prices for the pound now.

Still, for the price to drop, transactions need to occur. There will always be a buyer or a seller willing to complete a transaction at the current price, for a variety of reasons. For example, large corporations are not in the market to make a profit from currency exchange rates, but rather to hedge their currency exposure, so they’ll be happy to trade at the current price.

However, as sellers want to dump their pound holdings, and buyers are not willing to increase their buying prices, the exchange rate inevitably drops. There might be a transaction with a buyer at 1.3020, then at 1.3015, and then at 1.3008.

But, as the number of sellers is higher than the number of buyers, sellers will need to continue to drop their prices in order to get rid of their pounds. This is, in essence, how an exchange rate falls after a weak market report.

Of course, the opposite is true when the report comes in better than expected. Buyers are now competing to buy pounds at higher prices, while sellers are reluctant to sell at lower prices. That’s when the exchange rate of GBP/USD rises.

How Markets Establish Equilibrium

Now that you know how prices are established in the markets and why they go up and down, let’s take a look at how markets establish equilibriums.

Equilibriums are price levels where buying and selling pressure are balanced. While each price level at which a market is trading theoretically represents an equilibrium in the market (since buyers and sellers agreed to complete a transaction at that level), we’ll be talking about equilibrium levels in the forex market as a result of market fundamentals.

One of the most popular models to find equilibrium levels in the forex space is the Purchasing Power Parity (PPP). The PPP calculates the fair value for an exchange rate based on the relative prices of goods and services between two countries.

For example, when the price for a good in one country is higher than the price for the same good in another country, there is theoretically no obstacle for a citizen of the first country to travel to the other country, buy the product at a lower price, and return to his home country.

To make this clear, here is another example. Let’s say the price for a Mercedes of the same model is EUR 100,000 in Germany and $120,000 in the United States. This implies that the current EUR/USD exchange rate should be 1.20.

If the current exchange rate for EUR/USD is, let’s say, 1.10, a US citizen could travel to Germany and buy the exact same car for EUR 100,000 by exchanging $110,000. Instead of buying the car in the US, why shouldn’t he just travel to Germany and buy the car there?

And as many more US citizens realize that the car is cheaper in Europe, the exchanging of US dollars to euros would eventually lead to buying pressure in the EUR and to the formation of a new equilibrium exchange rate in the EUR/USD pair, i.e. the EUR would theoretically appreciate towards 1.20.

Of course, there is a number of obstacles here. The PPP theory implies that there are no import taxes, that transportation costs are near zero (our friend from the US still needs to transport the car back to his home country), and that the goods are homogenous, i.e. that there is no difference between the same Mercedes produced and sold in the US and the Mercedes produced and sold in Germany.

Still, the PPP model has a proven track record to correctly identify fair values in exchange rates over the long term. It usually takes a few years for an exchange rate to return to its PPP exchange rate, but over time, it will most likely happen.

An interesting approach to the PPP model was created by The Economist magazine. It’s called the Big Mac Index because it compares the prices of McDonald’s Big Macs across the world. The Big Mac is a perfect product for the Purchasing Power Parity model, as it is the same product in any Mcdonald’s in the world.

The Big Mac index had some amazing predictions that proved to be correct. To learn more about the index, simply search for “the big mac index” on the internet.

So, the PPP is one of the many valuation models in the forex market. Other popular approaches include the Balance of Payments approach, the Monetary approach, the Trade Balance approach, and the Portfolio approach, to mention a few.

Markets and Human Emotions

The markets are a huge collection of individual market participants which include banks, hedge funds, central banks, individual traders, individual traders, commercial companies, and even tourists who want to exchange their domestic currency for Swiss francs to enjoy a ski holiday in the Alps.

With so many individuals in the market, it’s almost impossible to remove human emotions from the market behavior. Even with the rise of algorithmic trading, human emotions still play an extremely important role in price discovery.

So, what emotions are represented in the markets? At a fundamental level, fear and greed are some of the most powerful emotions that run the markets.

When investors are fearful, they tend to sell their holdings which in turn leads to a wave of selling pressure and a collapse in the price. When fear is at the highest level in the markets, the prices usually touch the bottom and start to reverse. This is why the best time to buy is when fear is the greatest in the market. In other words, when everyone is fearful, be optimistic, and when everybody is optimistic, be fearful.

A good indicator to measure fear in the markets is to use the VIX index. The VIX, also called the Fear index, measures the implied volatility of puts and calls in the S&P 500. You just need to remember that, when the VIX is high, fear is high, and when the VIX is low, fear is low. Under normal market conditions, the VIX usually trades around 20.

Fear is also the reason why many traders lose money in the markets. When a trade turns against an inexperienced trader, he or she often sticks to the trade, hoping for the market to reverse. Fear of losing money in the markets is high among beginner traders, which is also the reason why most of them make the usual beginner mistakes of letting their losing trades run.

On the other end of the spectrum, greed is also a powerful emotion in the markets. In small doses, greed can be good as it allows a trader to maximize his profit potential. However, too much greed can also lead to costly trading mistakes, such as placing unreasonable profit targets.

Both fear and greed can be easily controlled by having a written trading plan. A trading plan should include your trading strategy, the markets you’re trading, the market hours you’re trading, risk management rules, entry and exit rules, and other rules that can be defined to make trading as systematic as possible. If you follow your rules, there is no place for fear or greed in your trading.

Final Words

Markets are a complex interrelationship of individual market participants that have different objectives. Some of them participate in the markets to make a profit from rising and falling prices (speculators), some participate to stabilize the financial markets (central banks and governments), while others want to hedge their international exposure or simply have a need to buy and sell different currencies because of their daily business.

Whatever the reason for their participation, prices move every second, minute, and day. When demand exceeds supply, the price usually rises, and when supply exceeds demand, the price usually falls. A transaction occurs only when a buyer and a seller agree on a certain price, so each movement in price is fundamentally driven by a new transaction.