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How do you know whether a market is more likely to rise or fall? The answer lies in decoding price action. Price action analysis is the science and art of interpreting market movement into profitable trading ideas.
Price action tells us the story of the battle between bulls and bears. And price action is what you should focus on if you want to profit in the market. You may ask yourself: “How can I interpret price action?” How do you know whether price action is indicating that the market is going up or down? And how do you recognise which price action patterns to look for? In this article, we discuss price action from a different angle, through the concept of Depth of Market (DOM).
What is price action?
Have you ever wondered how price actually moves from one level to another? Let’s look at the following example.
Imagine a currency pair with a bid and offer of $1.00 / $1.01. Clearly, if you want to buy immediately, you will have to lift the offer at $1.01 – that is, buy from someone who is offering at $1.01. Likewise, if you want to sell immediately, you will have to hit someone’s bid at $1. So how does the stock move up one cent to a new, higher bid/offer of, say, $1.01/$1.02? This is a fundamental question that most traders overlook. You might say it is because there are more buyers than sellers, but that answer is wrong. It is not the number of buyers that determines price movement, but the size (volume) of the buy positions. An institutional “buyer” such as a bank, hedge fund or large company can hold buy positions many times larger than those of small retail traders. So here is exactly how price moves
It is not the number of buyers that determines price movement, but the size (volume) of the buy positions.
The image above is a simplified model of the order book, commonly called the Depth of Market (DOM). The DOM essentially shows all limit orders at every price level. The bid at $1 is called the inside bid and the offer at $1.01 is called the inside offer. This is the first level of bid/offer. For the market to move up to a new bid/offer of $1.01/$1.02, the offer of 100,000 shares/units at $1.01 must be completely filled. For example, if a buyer needs to buy 200,000 units right now, the 100,000 shares offered at $1.01 are absorbed and the remaining 100,000 shares become a buy order on the bid at $1.01.
If a buyer needs to buy 200,000 units right now, the 100,000 shares offered at $1.01 are absorbed, the remaining 100,000 become a buy order on the bid at $1.01, and price rises to 1.01.
Can you picture how price moves now?
How does price manipulation happen?
The scenario above is only a simple overview of price action. But a great deal happens behind the scenes of the price board, where price manipulation can take place at any time. Let’s use the Depth of Market (DOM) below as an example to illustrate this.
An example of price manipulation.
At the $1 bid, you notice limit buy orders for 110,000 shares. Those 110,000 shares can be seen as the current buying demand at $1. Suppose you see a buy order for 500,000 shares at the $1 bid, while the offer at $1.01 is still 100,000: that suggests more demand to buy the stock than to sell it. However, seeing the total volume of resting orders does not tell us whether they were placed by one trader or many. It could be a single “big player” institution placing a 110,000 buy limit at the inside bid, or 10 different traders bidding together. This is important to understand because it can tell you whether the buying demand is real.
Placing resting orders at bid/offer levels does not mean they have to be filled. The traders who placed them can cancel them whenever they like, which adds complexity and creates scope for manipulating price behaviour. A large player can fake it by stacking large buy orders on the bid and small orders on the offer to trick others watching the Depth of Market (DOM) into thinking that buying demand exceeds selling.
Placing resting orders at bid/offer levels does not mean they have to be filled.
So what happens is that when traders see this, they want to get in on the buy side and push the bid higher. What they do not realise is that the Big Boys are waiting to sell into them. For example, the big players may want to sell 400,000 shares at $1.01 to build a short position, but they do not want to show their intentions to the market, because that would openly tell the market what you are trying to do. If they did, everyone else would jump in and sell ahead of them, pushing price lower. So they use fake buy orders to create artificial demand, then offer an initial small lot of 80,000 shares at $1.01.
Once the initial 80,000 shares are filled, the offer side immediately shows another sell order for 80,000 shares. And they keep doing this until all 400,000 shares are sold.
Once the initial 80,000 shares are filled, the offer side immediately shows another sell order for 80,000 shares. And they keep doing this until all 400,000 shares are sold.
At this point, the market suddenly no longer looks bullish. The big players’ next move is to push price down by sweeping all the current buy orders at $1 and $0.99. When this happens, small retail traders who were “squeezed” into buying at $1.01, $1.00 and $0.99 suddenly feel they need to exit their trades, and some even flip to the sell side. This adds further selling pressure and pushes the market lower still. This is an example of classic price action manipulation that happens every day in the market. Of course, that is only what creates a small price move. On a larger scale, the sum of all these price moves forms candlestick patterns, and the sum of all candlestick patterns forms chart patterns.
Now, do you understand a little more about what price action is? Goodbye for now, and see you in the next articles.
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