Understanding Liquidity and Market Pullbacks
Nature abhors a vacuum
If you want to understand why the market pulls back in an uptrend, keep "Nature abhors a vacuum" in mind.
- An uptrend starts.
- Price is at 1245
- There is ZERO buy side liquidity above 1245
- There IS buy side liquidity below 1245
- There IS sell side liquidity above 1245
- Market buy orders 'eat' the sell side liquidity and break through the ceiling
- Price moves up and up and up
- We are now at 1250
- There was no buy side liquidity above 1245 before
- There will be SOME buy side liquidity between 1245 and 1250 but it will be NEW liquidity that got placed there as price moved up.
- Some of this new buy side liquidity will be Market Makers who were SELLING as the market moved up
- Other people will have submitted new buy side liquidity on the way up
- Other people will still be THINKING about submitting buy side liquidity
The area between 1245->1250 now has (to an extent) a 'liquidity vacuum' on the buy side. The liquidity hasn't had chance to build up in that area as it has on the sell side. We are at 1250 - we have moved up into an area where sell side liquidity has been sitting for a while. We moved up into an area where no buy side liquidity existed before but where sell side liquidity exists. The ceiling is strong and the floor is very weak. Any uptrend will have a mix of market buyers and market sellers eating liquidity on both sides. We have market buyers and sellers, we have a strong ceiling and we have a weak floor.
- The market starts to move down as the weak floor is consumed on relatively little market selling
- Some new sellers may be thinking 'reversal' and jump on short
- As we move down, we move 'further back' in time OR to prices that have been traded a while back and where there has been more time to consider a buy side limit order
- We move down and the floor gets a little thicker
- At the same time, we move down into an area with ZERO sell side liquidity, the vacuum is now being created above us.
Eventually, we get to a point where we have a thicker floor below us and a relatively thin ceiling above. Price starts to move up and a whole bunch of traders (like me) think "Continuation". Anyone that sold the pullback starts to feel a little queasy and pukes out (by buying); we may see a little acceleration to the upside as the market becomes quite one-sided. Then the process starts over again.
The above picture shows price and cumulative delta. To understand cumulative delta, see the following article: http://www.trade2win.com/articles/1670-trading-cumulative-delta-indicator
We can see here a typical intra-day move. The top chart shows the price and the bottom chart shows the cumulative delta. Price moves down about 14 points with 2 major pullbacks. You can see that as the market is pulling back up, the cumulative delta hardly moves up at all (relative to the down move). We can safely say that this up move was caused by lack of sell side liquidity as a 'vacuum' was created there by the down move. It didn't take many buy market orders to move the price back up to where the liquidity was.
This is where we have the confidence to sell into a move up because we know that the move is caused by a temporary lack of sell side liquidity.
The market is like a hi-rise building. It has floors (buy limit orders) and ceilings (sell limit orders).
It takes market orders to eat these floors & ceilings.
As you move up and go through a ceiling, it takes time to rebuild the floor behind you.
This lack of a floor, or 'liquidity vacuum' is the cause of pullbacks in trends.
This represents opportunity for you. Once you know that the market is 'vacuuming back', you suddenly aren't scared of fading that pullback.
Of course, other techniques such as Tape Reading will tell you where the pullback has ended.
Peter Davies can be contacted at Jigsaw Trading