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Three principles form the
foundation upon which my whole strategy for trading and investing is
based. While everyone's trading strategy will always be different,
perhaps today's article will help set you on a path that allows you to
focus on what is real and not what you feel...
The first principle states that "Price movement in any free market is a
function of an ongoing supply and demand relationship within that
market". The second law states that "Any and all influences on price
are reflected in price." Lastly, the third law says that "The origin
of motion/change in price is an equation where one of two competing
forces (buyers and sellers) becomes zero at a specific price." First,
understand that there are always two competing forces at work in the
market, buyers and sellers. Our goal is to quantify those forces and
identify price levels where the imbalance is greatest as this creates
change, or movement in price.
Price movement in any free market is a function of an ongoing supply and
demand relationship within that market.
Put quite simply, a trading and investing market is made up of three
components: buyers, sellers, and a widget being bought or sold. These
widgets may be shares of a stock, S&P futures, foreign currencies,
bonds, and many more tangible and intangible "widgets". For example,
let's say the widget is a stock. This stock has some value. That value
or "price" as we call it is determined simply by the supply and demand
for the stock, which is the ongoing interaction of all the buyers and
sellers taking action with regard to that particular stock.
A market is always in one of three states:
First, it can be in a state where demand exceeds supply which means
there is competition to buy and that leads to higher prices. What does
this look like on a price chart? A "pivot low" is a perfect example.
Second, it can be in a state where supply exceeds demand which means
there is competition to sell and this leads to declining prices. What
does this look like on a price chart? A "pivot high" is a perfect
example.
Third, it can be in a state of equilibrium. At equilibrium, there is
no competition to buy or sell because the market is at a price where
everyone can buy or sell as much as they want. However, as the market
moves away from equilibrium, competition increases which forces price
back to equilibrium. In other words, competition eliminates itself by
forcing markets back to equilibrium. Even though equilibrium is where
the majority of candles are, we don't necessarily want to trade in
that area.
How you quantify the supply and demand in any market is always the same.
Exactly what this looks like on a chart and the mechanical rules to
take advantage of a low risk high reward high probability trading
opportunity are a topic for another article.
Principle 2: Any and all influences on price are reflected in price.
At any given moment, there is tons of financial information being
created and passed on around the planet. This information can be in
the form of an earnings report, news, income statement, analyst
opinion, economic report, terrorist attack, and so on. All this
information creates thoughts and perceptions that are different for
everyone depending on their individual BELIEF system. Be careful to
notice that most humans assume others' belief systems are the same as
their own. This, of course, is simply not true.
As I have said before, beliefs lead to ACTION and in trading and
investing, action is either buying or selling. Each action to buy or
sell takes place at a specific price. Therefore, price is all the
consistently profitable trader and investor needs to focus on. Adding
ANY other information will distort your perception of the
supply demand reality of any given market.
Principle 3: The origin of motion change in price is an equation where
one of two competing forces buyers and sellers becomes zero at a
specific price.
Let's now put numbers to the simple supply and demand I keep
mentioning. Here, we have 300 buyers and 200 sellers at $20.50. Price
will remain stable, meaning supply and demand will appear to be in
equilibrium until the 200th seller sells. Price will begin to increase
or CHANGE when the last seller has sold. It is when the last seller
sells that we are left with 100 buyers and no sellers. One of the two
competing forces has exhausted itself. In this case, it was the
sellers. What appeared to be supply/demand equilibrium was actually
disequilibrium or imbalance. It just took a certain amount of time for
this unbalanced equation to play out.
In other words, motion of price occurs when one of the two competing
forces becomes zero. The two competing forces are, again, supply and
demand. The time it took for that imbalanced relationship to produce
movement is purely a function of the actions of the two competing
forces.
While everything in this piece only means something if you know what
supply and demand looks like on a chart, the goal of this piece was to
get you to turn back the clock and focus on the foundation of your
trading strategy.
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