Author: TradeStream | Improve Your Trading

Compiled by: Deep Tide TechFlow

Trading: If we choose to act where most are willing to trade based on common sense... then this may imply that we do not possess more valuable information than others.

Metaphor of Market Behavior One: The Puzzle

I like to describe market behavior using puzzles. One can imagine the market as a person trying to complete a puzzle, while the trading volume represents the puzzle pieces. The market strives to fit all the pieces together. By analyzing the distribution of trading volume, we can more clearly identify where 'fragments' are missing. When the market finds areas with a lot of fragments (i.e., where trading volume and time accumulate), it will attempt to allocate these fragments to areas with fewer fragments (i.e., where trading volume and time are less).

How the Market Chooses Direction

Sometimes the market lacks 'fragments' on both sides, so how do we determine which side it will fill first?

This reminds me of a theory about human behavior in the book (Atomic Habits). In such cases, we need to focus on two key points:

Attraction: People generally hope that actions will yield returns, and the market is no exception, as it reflects human behavioral patterns. As discussed earlier, we tend to avoid overly crowded trading scenarios, and more attractive strategies are often trades that oppose the majority of displaced participants, especially when we have clear structural reasoning.

Reducing Resistance: According to the 'Minimum Effort Principle', the more effort something requires, the less likely it is to happen. If resistance is too great, the difficulty in reaching our goals will also increase.

Metaphor of Market Behavior Two: The Trolley Problem

Imagine the market as a train, and this train is like a 'killer' eager to 'hunt'. When we act in the fair value zone, both sides of the market are crowded with participants, making it hard to predict which side it will choose to 'hunt' more people. However, once the market chooses a side, the other side becomes the only option, simplifying our decision-making.

What is Liquidity?

Liquidity refers to whether there are enough counterparties in the market to trade. When we trade, we either consume liquidity or provide it. If prices remain stable in a certain area (i.e., a balanced zone) or cannot fluctuate smoothly, it is because buyers have failed to consume enough liquidity; conversely, if prices can fluctuate smoothly, it indicates that buyers have successfully consumed sufficient liquidity.

Limit Orders vs Market Orders

Limit orders 'add liquidity', while market orders are tools to complete trades and consume that liquidity. Passive liquidity (limit orders) is often more influential because limit orders tend to determine market structure, while aggressive market orders get absorbed at critical points.

Why are limit orders more influential? Because when you execute a market order, you have to cross the bid-ask spread, which means you will immediately be in an unrealized loss position after placing the order.

What is the Spread?

The spread is the difference between the asset's buying price (ask price) and selling price (bid price). Market makers provide liquidity through the spread, meaning that the price for immediately buying the asset is usually slightly above the market price, while the price for immediately selling is slightly below the market price.

Suppose the current price of an asset is 10.00, and the asterisk represents each contract. If we want to buy immediately, there is no quote at 10.00, because if there were, market makers would not be able to profit. Therefore, they will set the advertised liquidity slightly higher, for example, placing four contracts at 10.01 to capture this small difference.

If we decide to buy three contracts, we will transact at the price of 10.01. But what if we want to buy more, say 15 contracts? We will need to cross the spread until we find enough orders to complete the trade. As a result, the price will eventually be pushed to 10.03, as only at this price level are there enough contracts to meet our demand.

Through this example, we can understand why limit orders are often more influential. The price impact of small-scale traders can be negligible as they do not encounter significant slippage. However, if someone wants to purchase 500 contracts and there isn't enough liquidity nearby, they will have to cross a significant spread, causing substantial price fluctuations.

If traders choose to place orders in areas with sufficient liquidity, they can avoid significant slippage. So, where is liquidity typically concentrated? The answer is above swing highs and below swing lows. This is because most technical analysis-based traders exhibit similar behavior when hitting stop-losses, and these locations often become concentrated areas for stop-losses, where prices can easily reverse.

So, their stop-loss is your entry point? Indeed.

Summary

  • Impatient buyers or sellers push prices with market orders (the active side), consuming liquidity.

  • More patient buyers or sellers prevent price fluctuations with limit orders (the passive side).

We can use a metaphor: a market order is like a hammer, while a limit order is like the floor or ceiling of a building. To break through a floor or ceiling, sufficient hammer force is needed to shatter it.

What happens when the floor is broken? Prices will quickly move to the next floor.

Once the price reaches the next floor, moving upward becomes easier because the ceiling has been broken, creating a 'gap' that allows prices to fluctuate more easily in areas of scarce liquidity.

Liquidity cascades are a very effective way to make money because we are trading with those price-insensitive groups forced to trade (e.g., traders being forcibly liquidated). But we need to be clear about what we are trading.

If you are trading a liquidity premium, this effect is usually very short-lived, lasting at most 10-15 seconds. In a cascading environment, this situation can change. In this case, you need to judge whether liquidity has fully recovered from the initial fluctuations.

The chain effect of momentum shifts, though not as reliable as liquidity premiums, is more persistent (most people think they are trading liquidity premiums when they are actually trading this momentum effect).

The first method (liquidity premium) is more suitable for PNL attribution (i.e., analyzing the reasons for profit) and is the more ideal mode of operation. The second method (momentum effect) captures the core part of significant fluctuations, but comes with greater volatility and looser risk control.

Overall, liquidity cascades can lead to supply and demand imbalances, as a large number of price-insensitive traders flood in, overwhelming the order book with too many active traders. However, once the market stabilizes, prices can more easily return to areas that failed to form sufficient volume due to rapid fluctuations.

After all, the market is a two-sided auction mechanism that usually tests those low-volume areas for two reasons:

  • Such paths have less resistance;

  • The market seeks efficiency; it will test these areas to see if anyone is willing to trade at these price levels.

As a result, the market experiences a kind of 'mechanical rebound' because the order book needs time to rebalance. At this point, only a small amount of trading volume is needed to drive price fluctuations. Once the market stabilizes, price movements will rely more on momentum, accompanied by higher volatility, but can also capture more profit.

Remember, high volatility tends to be followed by high volatility, and low volatility tends to be followed by low volatility; this is called the volatility clustering phenomenon. Therefore, seize opportunities and adjust your risk management strategies based on the changing market conditions.