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long post
first of let me start with quoting here:
"blessed are the ones who read this message"
:-)
anyway.
buyers and sellers what is often called supply and demand
do move the price up or down but the picture is more
complex than you think.
there are about 4-5 distinct types of markets out there, and all
of them are a bit different:
Nasdaq has a so called limit order book or L2 book where
market makers and ecns are stacked up on both sides, you
can see that book.
Nyse where you got limit book that you cant see, where there
is only one market maker - the specialist.
Open out cry futures where you have floor market makers
and there is no limit book but there is floating paper orders.
Electronic futures markets, where you can see the limit book -
similar to Nasdaq but rules of execution are different.
all of these markets have different rules of execution, different
types of orders but they all have common thing - supply and
demand moves the price. However this is the most important
thing: price is the queen and the PRICE DISCOVERY mechanism
is the same in any of those markets: "price is discovered in process of
finding equilibrium between supply and demand". and the way it works is
this:
Price discovery algorithm ( courtesy of my research of many years ):
1. price ( bid / ask vs hit / take )establishes new supply land demand
levels
( bid size / ask size vs hit size / take size )
2. this "fresh" supply and demand level at the current price finds it's
equilibrium
during which process a new price is created ( price and volume ).
3. any disequlibrium left at the current price levels will move the price up
or down to FIND NEW EQUILIBRIUM LEVEL.
4. go to step one and repeat process.
example in Nasdaq L2 CSCO:
total inside bid - size Bid = 100 ( times 100 of course ) - demand
total inside ask - size Ask = 20 - supply
now here it's a little tricky...
total size hit - size hit = 200 - supply - these are the market sell orders
that hit the bid and that you CANT see because there is no market or stop
order book
in nasdaq you can only see them on time of sales when the transaction
already
happened.
total size take - size take = 50 - demand same as above but market buy
orders.
Question: where is the price heading next??? ah, that's hard isn't it.
but not so if you know the price discovery math and trade L2.
60 60 1/16
BID = 100 || ASK = 20 ( visible in L2 montage )
-----|-------------|------
HIT = 200 || TAKE = 50 ( invisible )
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V V
priceprints priceprints Vol at bid = min ( bid, hit ), at ask = min
ask , take )
60 100 60 1/16 20
disequlibrium left
bid - hit = -100 - supply - still needs to be equalized
ask - take = +30 demand - still needs to be equalized
in this case the most likely scenario is that
bid will bill pulled down and ask will be pulled up
but because bid pull is much higher then ask pull ( there are 2 types of
pulls
vertical and horizontal ), spread will be pulled apart, but someone will
come in to close the gap and front ( front run ) probably on the ask side,
seeing larger prints at the bid. is this case the total disequlibrium is -70
and
price will likely to go to the next level down to find the equilibrium
needs to find +70 ).Hard enough ??? to understand. And all that happens in
a split of a
second :-) on L2 screen.
the question is: is this tradable? and the answer
is yes and no. because supply and demand are so elastic and so unpredictable
that you cant say what's going to happen next.
on top of that: new price level brings forth new supply and demand levels
and the whole thing feeds on itself and is very dynamic.
from all of this comes the MOST IMPORTANT LAW OF THE MARKETS:
but first.
there are two distinct types of supply and demand:
fresh - someone ready to buy 10,000 csco or sell 20 sps - the potential
supply or demand that is not in the market yet.
stale - someone bot 10,000 csco or sold 20 sps - this actually becomes
potential supply ( bot 10,000 now you gotta sell it to close the
transaction )
( all of that is from the law of the zero some game )
here is the catch: we can only predict the price with 100% accuracy
( listen up people, here it comes ) if we new 100% of order distribution
which the same as supply and demand distribution. since we don't
know and can not know and will not know both fresh and stale
supply and demand at different price levels ( even if we could count
all stale supply/demand - all of those traders that sold and bot at
different price
levels we still don't now fresh supply and demand - all of those who will
buy or sell ) - PRICE CAN NOT BE PREDICTED.
here is the law of the zero sum game in supply and demand terms
( not in dollar terms which i omit here )
FreshDemand + StaleDemand = FreshSupply + StaleSupply.
or simply for all buyers there must be a seller( using layman's math here )
this same law could be rewritten as:
Fdem - Fsupply = Ssup - Sdem or total supply = demand = equilibrium
Fdem - Fsup + Sdem - Ssup = 0
we don't know who and how much will by - Fdem, Fsup = ???
we don't know who bot or sold - Sdem, Ssup ???
further more we don't know at which levels people will enter
or exits - we don't know their risk levels = at which price they will
be getting out or getting in. PRICE IN ITS PURE FORM IS
UN-PRE-DIC- TA - BLE! there is no way to calculate future price
using some formula or something so throw out your imaginary holy
grails and neural nets... etc. it simply is unpredictable, period.
all of your systems all of your indicators all of works, is down
the drain - it was an illusion....
at first it sound very depressing ( and believe me i was depressed for a
while when i came to this conclusion ) but there is a bright side, yes
there is!!! it comes from yet another law of supply and demand:
but before i go into this you need to realize that price is unpredictable
first, you can't predict it - second, you have to put it all behind you
and go FURTHER OUT.
who was able to read this till now here is the reward for you:
these laws are all originally formulated by me ( someday i might write
a book about it )
law1: the law of TIME AND PRICE.
for every time movement there must be a price movement -
this is the most fundamental law of the markets - it basically tells you
that price must move with time or else who want to buy and sell
when it's a flatline, there will be no profits generated... you understand?
for a math person it simply reads
P = f ( T ); price is function of time. ( the more time passes the more
price moves )
law2: the law of DISEQUILIBRIUM
Price is a function of supply and demand
there are two of them ( simplified )
a. if more buyers than sellers then price will go up
b. if more sellers than buyers then price will go down.
P = f ( S, D ); price is a function of supply and demand
3. the law of EQUILIBRIUM
if supply = demand price will go sideways or
its a turning point.
these laws , folks , that you've been looking for - it's the "holy grail".
from those laws we can deduce the most important thing that you
should be doing: as price will rise supply will increase and demand
will decrease. if price will fall demand will increase and supply will
decrease: hence my nick name buy low sell high.
PRACTICAL IMPLICATIONS: THE "mantras" :-)
1. realize that price is ultimately unpredictable but probable.
price is driven by price expectation and then supply and demand.
2. design your system around the concept of un-pre-dice- ta-bi-li -ty!
and probability.
3. make sure the system!!!!!!!!!!!! buys low and sells high - the only
way to make money.
4. realize that price will always move, and is very dynamic.
5. realize that supply and demand move the price but at same time
price creates supply and demand - a chain reaction.
6. realize that trading is a zero sum game, for every win there is a loss,
for every blown out account there is a new car or a better house.
7. ultimately price is driven by price expectation - self fulfilling
prophecy
concept: price expectation ( price valuation ) comes first then supply and
demand then real price and then repeat. ( i am omitting price expectation
here since this the most complex issue )
the most important item here is number 2 and 3.
for the scientists and philosophers and scholars out there realize that
the above laws are very deterministic yet at same time things are left
to chance - price movements are probabilistic. and that we yet again
have a set of iron clad laws mixed with freedom of choice....
you can describe price movement in mathematical terms but you can't
predict it analytically. you can only play probabilities and probabilistic
models. price can exhibit virtually any possible curve and there is
no magic in there. there is little predictability in price.
there is of course more math in this and a lot more to say about this.
if someone has questions let me know. i know a lot
about price, time, volume, supply and demand, etc...
still i ain't rich yet... just getting there.
Bilo.
this is all original, straight out of my neural net in between my eyes,
a lot of hard work and long hours trying to figure out, how the f...
can this price move up and down so much and what moves it.
also i did not go to Wharton.
i got another post coming with some examples.
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