Wednesday, August 02, 2006

Reading the Market: More on What Every Short-Term Trader Should Know

In an earlier post, I outlined a reality that every short-term trader should know. Here I want to follow up on that with a practical application and example.

Imagine the market oscillating from moment to moment. It trades a number of contracts at the bid price, then several at the offer, then more at the bid, and yet more at the offer. This is happening from second to second as you focus on the order book and what is actually trading. What is actually trading is different from the bids and offers in the book, which may or may not actually trade, given the frequency with which large traders will pull their bids and offers before they are hit.

So we want to focus on what is real. What is real is what trades and *where* it is trading. Second to second, it is trading alternately at the bid and offer.

When a large trader lifts 500 from the book (i.e., purchases 500 contracts at the market's offer price), that, in the context of the moment-to-moment market, is a breakout trade. The only reason for buyers to take the offer price is if they think the market's oscillation is going to end and we will find a new, higher bid-offer range.

In that very short-term context, every buyer at the offer and seller at the bid is a breakout trader. The degree to which the market is trending at this shortest timeframe is reflected by the ease with which these breakout traders get paid out. In a rising market, the purchaser of 500 contracts at the market will find other demand coming in to support the price and the market will move higher.

If a large trader lifts an offer or hits a bid and doesn't get paid out, by definition his or her order was not sufficient to budge the market from its oscillation range. (And, of course, if the large trader' s position goes more than a tick in the red, the market is trending against that trader).

Yesterday AM, I had two points of profit in a short trade. The market had already made a nice down move and suddenly a seller hit the bid with 1500 contracts. I knew from experience that, on average, large size hitting bids after sizable down moves have already occurred often provides liquidity for smart buyers who perceive short-term value in the market. When the market did not immediately go lower in the face of that large trade, I took my profit and avoided a nasty run upward shortly thereafter.

If the market could easily absorb a large sell order after having moved steadily lower on orders that were no larger, that told me that we were nearing an equilibrium point. If the large trader is not getting paid out, the market is not trending on the shortest time frame.

This is not theory. This is not hammer and shooting star chart patterns, Fibonacci retracement numbers, wave sequences, oscillator readings, news events, statistical models, or monetary/economic conditions. This is simply how the market is trading and the ebb and flow of supply and demand in the marketplace.

When you combine historical market tendencies (such as those researched on this blog) with a keen reading of real-time supply and demand shifts, it is indeed possible to generate short-term edges in the market. The key is watching the market and what is actually happening, not getting lost in theories and what you think should happen.