1) Who is in the market? - If I want to play poker at the casino, I'll watch the tables for a while. I want to get a sense for who is playing, because that will help determine if I play and how I'll play. If I want to play in a chess tournament, I'll study the past games of my opponents and calibrate my play accordingly. If I draw a team as a first round opponent in the NCAA basketball tournament, I'll want to watch film of that team and figure out how to set my offense and defense. It's no different in markets. We want to figure out who is trading, who we can potentially profit from. I trade the ES futures. For each half hour of the day, I know the expectable volume and the average variability around that level. I know that we can usually expect twice as much volume at the 10 AM period as at the 11:30 AM period, but with only a third more variability. What qualifies as high and low volume at one period is different from another. When we get meaningfully above average volume, I know to expect more directional market activity; when the market is well below average in volume, I know to expect a market dominated by market makers, not directional participants. Knowing a piece of news, a chart pattern, or statistical study is only helpful if there are participants who will act on that information.
2) What are they doing? - If we're seeing strong market participation, we now want to see if that participation is skewed toward buying or selling, or whether buying and selling are relatively balanced. I follow the data for upticks and downticks during the session ($TICK for NYSE shares; $TICK-US for all listed shares via e-Signal) to tell me whether buyers or sellers are dominant across the broad range of stocks. Values above +800 and below -800 are statistically significant, suggesting broad buying or selling at that moment. When we see persistent, elevated TICK readings, we know that participants are strongly leaning one way. At important market turns, we can see a drying up of those readings and, often, more balanced readings. Whether we trade or fade buying/selling depends upon whether participation is increasing (who is in the market) and whether the skew of their participation (what they are doing) are expanding or contracting.
3) At what prices are they doing it? - If we see volume and buying pick up, it's worth noting the price levels at which that is occurring. Should the volume and buying dry subsequently dry up, all those buyers are going to be vulnerable, especially should price return to their levels of entry. Very often we can see where buyers or sellers will be trapped by reversing markets by observing the price levels at which volume has expanded and the degree to which there was skewed buying/selling at those levels. Many, many market participants are overleveraged and can't take heat. They have to flee their positions if they start going against them. If you can gauge where their positions lie, you have a good chance of benefiting from their vulnerability.
The answers to these three questions help me understand what is going on in markets. I'm not interested in making market predictions in the absence of such understanding. Many times, those answers will not be clear. Volume and the breakdown of volume by buyers and sellers will not vary greatly from average. There won't be much edge. As any poker players knows, that information is valuable. Knowing when to not play is just as important as knowing when to bet large.
Markets are auction processes. Who is at the auction, the nature of their involvement, and the prices at which they're willing to transact all provide useful information to the participant. If I'm at the cattle auction and dozens of ranchers are looking to acquire steers and only a small number are up for auction, my strategy will be quite different than if only a few ranchers are present and a greater number of steers are available. No one at the cattle auction draws shapes on charts to figure out what to do, and no one at the cattle auction frets about the latest pieces of economic data or the pronouncements of central bank officials. If you understand the auction, you know how to participate, whether it's a stock auction or a livestock one.
Further Reading: Tools for Market Perspective
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