Market Mechanics – Part 1

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Why is the price at a particular level? What makes the price level change? How can the price change so much at some times and not so much at others?

These are questions I had after I started trading, especially when it seemed the price always went against me just after I entered a trade. So I learned more and more about how the market works. The picture starts off simplistically and gradually gets more complex.

 

It starts with a Difference of Opinion

A market only exists if there is a difference of opinion. If everyone agreed what something is worth, then there wouldn’t be a market. Traders will buy only if they think the price will go up. This is true for both buying to open a position and buying to close a position. Conversely, traders will sell, either sell to open or sell to close, only if they think the price will fall. So all it takes for a market to exist is for two traders to hold differing opinions about the current and future values of something.

Two traders, one thinks the price will rise from 1.0928, so he buys, and the other thinks the price will fall from 1.0928, so he sells. One buy order and one sell order are sent to the broker like this:-

prices1

 

Of course there are a lot more than 2 traders in the world. They all hold different opinions and sentiments, enter trades for different reasons and in different styles, and hold trades over different lengths of time. Technical traders will each have their own combinations of indicators and parameters to signal trade entry and exits, while fundamental traders will each have their own triggers for entry and exit. Traders use different styles of trading with different objectives; trend, reversals, swing, momentum etc. Traders participate in the market for different periods of time; scalpers may enter and exit positions within minutes or seconds, day traders within hours, swing traders within days, position traders and investors within weeks or months, and HFTs within milli-seconds. So because of these differences, there will be a stream of buy and sell orders, of the different order types (market, limit and stop orders) at different prices at all times.

 

prices2

 

This is a snapshot of the buy and sell orders at a particular instant. It only shows the limit orders in the order stack. If a market order is received, it is added to the stack at the price that will get it filled immediately. The market order can be either a fresh order submitted by a trader, or it can be the activation of a stop order by its trigger price.

 

What is Market Price

For example if a market buy order is received, it will be priced at 1.0929.

prices3

It will be matched with a sell order at that price and executed straight away.

prices4

 

The market buy order at 1.0929 has been matched with one of the limit sell orders at 1.0929, which is the lowest priced sell limit order. The trade has been completed, so both orders are removed from the orders stack. The market price (ie last transacted price) is 1.0929.

If a sell market order is the next to arrive, it will be added to the stack at the price which will get it filled straight away, ie 1.0928

prices5

So the market price changed by 1 pip from 1.0929 to 1.0928. This is the basic picture of how prices change.

Part 2 will show how and why price jumps, and how to benefit from this.