Sunday, March 22, 2009

At the Beachhead

To establish the context of discussion let's start by looking towards the market as it exists at the most granular level, orders. Orders are entered and then executed, modified, or canceled. Every single order goes through this life cycle. Each individual active order has two essential characteristics, price and size. Price is straightforward. Size just indicates how many assets to trade. Buy orders and sell orders are all vying for shares and being adjusted to reflect the perceived supply-demand situation. If you've never watched a daily chart with level II volume in real-time, the easiest way to describe it is a rugby scrummage where all of the orders influence the supply-demand balance. Orders are made either with the goal of obtaining shares or simply pushing the pile by influencing perception, but in the end all orders will continue to move the front lines (the spread) one direction or the other. Whenever orders meet up in the middle, they are compatible and will execute. When we plot these executions against time, they show up as the spot price chart that we're familiar with. Orders continuously join and leave the pile. Some orders are bigger and, like a large rugby player, will influence the pile more than others. Orders meet in the middle and transactions occur. The whole pile shifts around as orders are adjusted or orders dry up on one side, temporarily giving way to a route until more orders are encountered at a new price. This is what trading looks like at the knife-edge of the market.

The scrummage analogy is only missing one important element. While orders do pile up at the middle and tend to push the flow of new orders and order modifications, there are always some traders that are actually looking to make transactions, and because they're always looking for the best price, they tend to act like self-conscious singles at a bar. Everyone wants to be first but nobody wants to be desperate. For this reason, the leading orders will often get canceled or shuffled to a price farther away from the action, hoping to get a better price on the shares the trader wants. The compliment to this effect is that when there are few orders on the other side, traders who need their orders to execute will often go chasing after orders, hoping to avoid the feared situation of having no trading partners. There you have it: self-conscious singles playing date rugby at a bar.

The big picture is composed by these orders tossing back and forth like grains of sand guided by shifting and turbulent wind. The grains strike the knife-edge and cause it to jitter around as it moves forward through time. We represent this on various kinds of charts, but arguably the most useful is the simple daily candle chart. Each day is a discrete unit of time, so the candles cleanly represent what has gone on for each trading day. Line charts are somewhat deceptive in that connecting the dots creates the illusion that the stock is at one price on any given time interval. This blog will go on to eventually describe many levels of information in the charts and will also analyze many of the big-picture mathematical significance, but for now study this chart briefly and take in the concept that the market is composed of granular trades. All further analysis will be based on identifying the characteristics of these trades and what that description tells us about any market.

This topic is honestly a little bit below the target level of the book, so if you need further elaboration, I suggest looking up the following terms: Level II Quotes, Depth of Market, Order Book. A simple site like investopedia should be sufficient. If not let me know and I'll develop a more thorough introduction. If you're already more than familiar with these concepts or find yourself wondering why I'm starting at such an elementary level, please bear with me as I work up to more advanced concepts.

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