Fetor's Forex Blog – Discover The Secrets of Supply & Demand

Be sure to watch the GBP/JPY live trade video (previous post).

Below is a conversation I had with a friend of mine who is learning to trade. We were discussing what is behind the market economically and how the market sets prices for us to use as reference points so we know where to buy and sell in order to make profit. I thought there were some things in our conversation worth sharing and so I cut and pasted it below.

Take note of these market concepts and realities, because whether you like it or not or whether you choose to believe it or not, if you are trading you are in the middle of these ideas and they are influencing the market that is all around you. Getting these ideas down will help your trading exponentially in my opinion.

Hope this is some help to some of you. Enjoy.

[1:58:54 AM] Fetor: is the price expensive or cheap?
[1:59:02 AM] Fetor: are people willing to buy more or sell more?
[1:59:06 AM] Fetor: those are the questions
[1:59:19 AM] Karim: idk about expensive and cheap
[1:59:49 AM] Fetor: if the price is too expensive what do people do?
[2:00:00 AM] Karim: sell and run for the hills
[2:00:04 AM] Karim: wait for better price
[2:00:07 AM] Fetor: and if it is cheap?
[2:00:15 AM] Karim: load the boat
[2:00:20 AM] Fetor: correct
[2:00:24 AM] Fetor: fx is no different
[2:00:27 AM] Karim: but
[2:00:36 AM] Karim: what defines expensive and cheap
[2:01:02 AM] Fetor: it is defined by the price that the market is setting
[2:01:11 AM] Fetor: where are your reference points?
[2:01:17 AM] Karim: ok i see
[2:01:28 AM] Fetor: how do you know if something you are buying is a good price?
[2:01:32 AM] Fetor: let’s say a jacket?
[2:01:39 AM] Fetor: or a pair of pants?
[2:01:43 AM] Karim: relitive to other shops
[2:01:43 AM] Fetor: is it a guess?
[2:01:46 AM] Karim: and other products
[2:01:52 AM] Fetor: ok
[2:01:58 AM] Fetor: you use a point of reference
[2:02:02 AM] Karim: ya
[2:02:03 AM] Fetor: the market sets the price for you
[2:02:09 AM] Fetor: and you make your decision based on that
[2:02:14 AM] Fetor: i know I’m simplifying it some
[2:02:21 AM] Fetor: but I’m trying to get you to think a certain way
[2:02:29 AM] Fetor: why would someone sell?
[2:02:33 AM] Fetor: why would someone buy?
[2:02:37 AM] Fetor: those types of questions
[2:02:44 AM] Karim: ok
[2:02:46 AM] Karim: so
[2:02:52 AM] Karim: looking at taht daily chart you sen tme
[2:02:54 AM] Karim: sent me
[2:03:03 AM] Karim: lets say we didnt have the last few sessions
[2:03:13 AM] Karim: and price was comming down to the 6250 lvl
[2:03:31 AM] Karim: would you consider that cheap
[2:03:32 AM] Karim: ?
[2:03:44 AM] Karim: since hte market set a refrence there
[2:05:01 AM] Fetor: well….at that point though you are adding on to what you know about trending pressure and the probability of buying
[2:05:44 AM] Fetor: but first being able to say….here is where buying shoudl take place or selling should take place based on the price the market is setting then moves you to think about the next factors that would influence the buying
[2:06:02 AM] Fetor: candle patterns, chart patterns, trend lines, etc.
[2:06:22 AM] Fetor: this is that part that makes trading hard
[2:07:00 AM] Fetor: so when you get to a point where it is cheap enough to entice buyers you got to take some more steps
[2:07:15 AM] Fetor: cheap enough to POTENTIALLY entice buyers
[2:07:22 AM] Karim: ok
[2:07:23 AM] Karim: i see
[2:07:39 AM] Fetor: but as the price drops lower you can say that the chances for buying increases
[2:07:54 AM] Fetor: there are points where you won’t enter a buy because you know there are better prices below
[2:08:03 AM] Fetor: which we would mark as better entry points
[2:08:13 AM] Fetor: but as the price falls it changes the psychology
[2:08:20 AM] Fetor: it’s economics man
[2:08:26 AM] Fetor: the price then entices buyers
[2:08:31 AM] Fetor: cause we all want to make a profit
[2:08:47 AM] Fetor: so it’s a continuum as the price drops
[2:09:05 AM] Fetor: the cheaper it gets the more juicy it becomes
[2:09:12 AM] Fetor: then when the buying starts
[2:09:17 AM] Fetor: people jump on
[2:09:48 AM] Fetor: they buy it up and that is the demand aspect
[2:09:50 AM] Karim: http://www.screencast.com/users/mugged/folders/Jing/media/6a1acb56-ecee-4aba-8494-17507cbc35c4
[2:09:56 AM] Fetor: as long as there continues to be buyers the price rises
[2:09:58 AM] Karim: this is what i came up with on e/u
[2:10:11 AM] Fetor: until…..it gets too expensive
[2:10:20 AM] Fetor: and people are unwilling to pay a higher price
[2:10:30 AM] Fetor: when that happens
[2:10:31 AM] Fetor: …..
[2:10:36 AM] Fetor: well you know
[2:10:40 AM] Karim: ya
[2:10:41 AM] Fetor:
[2:10:47 AM] Karim: you see the link i sent you
[2:11:13 AM] Fetor: yep
[2:11:30 AM] Karim: is that a spot you would looking 2?
[2:11:35 AM] Karim: or am i missing the point
[2:11:37 AM] Fetor: absolutely
[2:11:46 AM] Fetor: market has set a price there
[2:11:54 AM] Fetor: it’s expensive there
[2:11:54 AM] Karim: ok
[2:12:00 AM] Karim: so
[2:12:10 AM] Karim: if we had a break of that s/r lvl
[2:12:17 AM] Karim: would that indicate a change in sentiment
[2:12:19 AM] Fetor: and as long as there is nothing else to influence people to pay more then it will fall when it gets there
[2:12:35 AM] Fetor: what time frame is that?
[2:12:39 AM] Karim: 4h
[2:12:52 AM] Fetor: i would say yes
[2:13:05 AM] Fetor: that a break there AND confirmation that there is support
[2:13:09 AM] Fetor: that’s why prices return
[2:13:31 AM] Fetor: the price returns to comfort people that people are willing to pay more
[2:13:42 AM] Fetor: so when the resistance then turns to support it’s telling you something
[2:13:47 AM] Fetor: about demand
[2:13:51 AM] Fetor: people will pay more
[2:13:55 AM] Fetor: and now the price is cheap
[2:14:11 AM] Fetor: because the market has set a new price
[2:14:17 AM] Fetor: and the new price is that that is cheap
[2:14:20 AM] Fetor: so people then buy
[2:14:26 AM] Fetor: until it gets too expensive
[2:14:29 AM] Fetor: then they sell
[2:14:38 AM] Fetor: and the process starts all over
[2:14:44 AM] Fetor: and you can do this then on any time frame
[2:14:51 AM] Fetor: all you have to do is adjust your targets
[2:14:57 AM] Fetor: and psychology
[2:15:04 AM] Karim: thats deep
[2:15:06 AM] Fetor: cause lower frames will deal with more static
[2:15:15 AM] Karim: (think)
[2:15:27 AM] Fetor: cause you are tightening the margin for error
[2:15:29 AM] Karim: i get what you are saying
[2:15:48 AM] Fetor: light bulbs go off?
[2:15:56 AM] Karim: yes
[2:15:59 AM] Fetor: ok…good
[2:16:08 AM] Karim: thanks
[2:16:17 AM] Fetor: np

[2:40:19 AM] Fetor: well….going with the expensive/cheap theory….at that point the market has set the price for us and at that point it is too expensive so we should see selling…BUT if there is influence to cause people to be willing to pay more (demand) because they beleive they can make a profit then buying will push the price higher until the market then sets a new price (reference point) as in the example where the previous resistance then becomes support as the market then sets that same point as the new inexpensive price. Once that happens and people are convinced of it, THEY WILL BUY.
[2:42:08 AM] Karim: nicly worded
[2:42:16 AM] Fetor: When that occurs and they enter with a buy they must have an exit and so that exit becomes the point where it is expensive. Now, they may enter out of fear or other reasons, but for the most part the vast majority of players are looking for the maximum profit.
[2:43:49 AM] Fetor: let me make that more clear….they may exit earlier because of fear or other reasons…but the vast majority of traders (institutions driving the market) will be looking for maximum profit
[2:44:58 AM] Karim: and in this case
[2:45:06 AM] Karim: max profit will be the next refrence point
[2:45:08 AM] Karim: right?
[2:46:07 AM] Fetor: in theory yes
[2:46:14 AM] Fetor: but that reference point could be a trend line
[2:46:16 AM] Fetor: s/r
[2:46:24 AM] Fetor: congestion
[2:46:30 AM] Fetor: again…general rules apply here for exits….and because the market is a in motion you have to be flexible and learn when to take profits, when to hold, when to increase position, when to cut a trade loose and reset, etc.
[2:46:32 AM] Fetor:
[2:46:39 AM] Fetor: and that is what takes practice
[2:46:46 AM] Fetor: and what makes trading difficult thing to master
[2:46:50 AM] Fetor: along with the emotions
[2:46:53 AM] Fetor: and psychology
[2:47:04 AM] Fetor: but it becomes easier to master when you understand what is going on
[2:47:07 AM] Fetor: and why it is moving
[2:47:16 AM] Fetor: and what traders are generally feeling
[2:47:18 AM] Fetor: and thinking
[2:47:30 AM] Fetor: then you can adjust accordingly

This past week I was reading Super Freakonomics, a new book out by Steven Levitt and Stephen Dubner. I ran across a section of the book I thought applies to the nature or nurture of trading. Are traders born or made?

For the sake of brevity, I’m going to summarize Levitt’s statements and conclusions found on pages 59 – 62.

If you were to take the birthdays of the players of a world-class soccer team you will find that there is a higher concentration of birthdays in the first 3 months of the year. A study on British soccer found that half of the players were born in the first 3 months of the year and the other half spread out over the latter 9 months. A study of German elite players yielded findings that showed 52 players being born between January and March as opposed to only 4 being born between October and December. The data is curious. Levitt goes on to explain that European youth leagues use December 31 as a cut off date in order to divide children in to competitive age groups. The premise is that those players born in the first part of the year have a developmental advantage over those born later in the year. When coaches are choosing which 7 year olds to play, the bigger boys are given playing time, instruction, and encouragement. It creates a yearly cycle that continues throughout their whole lives so that by the time they reach the elite leagues we find that the majority of players were born in the first 3 months of the year. Major League baseball players are also “victim” to the time of the year they were born. In the United States, most youth leagues for baseball have a cut off date of July 31 so you will find that a boy born in August has a 50% greater chance of playing in the major leagues than a boy born in July. These types of statistics can’t be based on nature or “raw” talent, but on practice, experience, and instruction time. The author makes a great point when he says, “Unless you are a big, big believer in astrology, it is hard to argue that someone is 50 percent better at hitting a big-league curveball simply because he is a Leo rather than a Cancer.

In light of this data, the author searched further to see if the concept of “raw talent” was legitimate. His journey led him to K. Anders Ericsson, a professor at Florida State University. Ericsson is a psychologist that uses empirical research to study the notion of natural talent. This is what Ericsson had to say on this matter, “A lot of people believe there are some inherent limits they were born with, but there is surprisingly little hard evidence that anyone could attain any kind of exceptional performance without spending a lot of time perfecting it. Or, put another way, expert performers-whether soccer or piano playing, surgery or computer programming-are nearly always made, not born.” Ericsson went on to say that mastery comes from what he calls “deliberate practice.” His definition of “deliberate practice” entails three key elements:

1. Setting specific goals
2. Obtaining immediate feedback
3. Concentrating as much on technique as on outcome

Trading is no different than soccer, baseball, piano playing or surgery. Success in trading is not based on raw talent, but on deliberate practice. Traders are not born, they are almost always made.

This is a fundamental skill necessary for trading. First of all the most important thing to grasp is that you should never ever trade without a stop. Even if you are looking to exit manually at a stop point you should at least have a stop in place somewhere beyond just in the case that something goes wrong. You don’t want to be floating a potential huge loss on account of just not having a stop in place.

The formula that I use is “what is the lowest possible risk that gives me the greatest opportunity to win.” Often what new traders will do is first determine stop placement on account of money management. You should not first dictate stop placement based on money management. Money management is a secondary concern. It is a concern, just a secondary one. We don’t want to choose our stop points based on arbitrary pip amounts. Every trade is different and may require a different stop distance depending on point of entry, etc. The first thing to consider when looking to place your stop is location based on real trading principles. That is why I use the above given formula. I first think through what is the lowest possible risk in a location that gives me the best opportunity to win.

Where are these “best opportunities to win” located? Since the market can only move in one of two directions and since the basic overall structure of the market is to work in zones of support and resistance then these “best opportunity to win” locations are going to be those prices where the probability of the market continuing against your position increases exponentially. Part of the process is then looking for critical price points where if the price continues you are going to want to liquidate your position to protect your capital. The good thing is that these points also provide you with the possible opportunity of exiting your losing position and looking for a new entry to recover loss. This is not to be done on a whim under emotional duress, but with proper understanding of market movement and an ability to think of the new position as a separate trade. You are in essence liquidating one position to protect capital, and taking a brand new position apart from the previous based on legitimate market price levels that have triggered a legitimate entry.

Once those areas have been evaluated then the issue of money management comes into play. At this point you need to determine potential loss. Adjustments might need to be made to the number of lots or your entry price in order for the established plan to fall in line with your money management. And that is how money management plays a roll. You first establish the stop points for the trade and then look for how your money management will fall into place with your established plan. Until your money management falls in line you wait and adjust accordingly, but you do not trade. The first object of any trader is to protect the capital that you have, the second being to manage risk.

Following these principles functions as a fail safe to keep you from compulsive trading. Compulsive trading is a common problem among new traders and a danger to your capital.