The Market Will Tell You Where It's Going

Summary: Too few of us traders these days ever stop to think about what the financial markets really are and how they operate - to the potential detriment of our trading performance. Oh, sure. We know about the various market participants, the structure of the markets, and the things that tend to drive price action. Those who have operated on an institutional level will also understand the inter-relationships between different markets, the types of positions which the various particip...

Too few of us traders these days ever stop to think about what the financial markets really are and how they operate - to the potential detriment of our trading performance. Oh, sure. We know about the various market participants, the structure of the markets, and the things that tend to drive price action. Those who have operated on an institutional level will also understand the inter-relationships between different markets, the types of positions which the various participants hold, and how that plays out in price movement. All that stuff, though, is one level above what really matters. The bottom line is that the financial markets operate to facilitate transactions. Think about that for a second. Exchanges are paid fees on each transaction. The more transactional flow the traders on the exchange generate, the more fee income the exchange makes. Market makers look to profit through the process of buying on the bid and selling on the offer. The more frequently they do that, the more money they make. So basically there is an institutional bias toward doing everything possible to generate as much trading volume as possible. Now the exchanges do higher level things like marketing and listing instruments they think people will want to trade. The market makers, though, move their bids and offers to facilitate increased trading activity. (Please note that my use of the term "market maker" does not imply just floor traders, but covers basically any person or institution who seeks to profit by exploiting the bid/offer spread). That last part is the main thrust of what I'm talking about here. Prices will always move to the level where they most readily facilitate transactional flow. When prices remain in a small range the implication is that both buyers and sellers find value at that level, though obviously they may fundamentally disagree on what the future will bring. When prices rise, it is because sellers no longer see value at the lower levels, while falling prices means the buyers are backing away thinking that current prices are too high. This is the core truth of the markets. Prices seek agreed upon value. If you understand that, you can go a long way in your trading. What you see on the price charts is the market seeking out and finding that value. Certainly, it can be a transitory thing because there are new bits of information coming in to the market all the time. As they do, market participants alter their perception of value, meaning prices have to move in search of the new value. It's the ongoing process which creates the price action we try to interpret and anticipate. At this point you might be thinking, "So what?" To profit in the markets you have to come up with a reasonable idea of where prices are going (or not going). On first glance it might not seem like knowing the process by which prices got to where they are helps in that regard. That's wrong, though. That market will first look for value where it found it before. By identifying where that value is, we can get a great handle on where the market is likely to go next. And we don't need any fancy indicators or quantitative studies to do it.