Bitget App
Trade smarter
Buy cryptoMarketsTradeFuturesCopyBotsEarn
Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations

ChaincatcherChaincatcher2024/12/10 05:00
By:Deep Tide TechFlow

High volatility is often followed by high volatility, while low volatility is often followed by low volatility.

Source: TradeStream | Improve Your Trading X Account

Author: TradeStream | Improve Your Trading

Compiled by: ShenChao TechFlow

Trading: If we act in places where most people are willing to trade based on common sense… then it may mean that we do not possess more valuable information than others.

One Metaphor for Market Behavior: Puzzles

I like to describe market behavior using puzzles. One can imagine the market as a person trying to complete a puzzle, while the trading volume represents the puzzle pieces. The market will strive to fit all the pieces together. By analyzing the distribution of trading volume, we can more clearly identify where "pieces" are missing. When the market finds certain areas with more pieces (i.e., places with more accumulated volume and time), it will attempt to allocate these pieces to areas with fewer pieces (i.e., places with less volume and time).

How the Market Chooses Direction

Sometimes the market lacks "pieces" on both sides, so how do we determine which side it will fill first?

This reminds me of a theory about human behavior in the book "Atomic Habits." In such cases, we need to focus on two key points:

Attraction: People generally hope that actions will yield rewards, and the market is no different, as it reflects human behavioral patterns. As we discussed earlier, we tend to avoid overly crowded trading scenarios, and more attractive strategies are often trades that oppose the majority of displaced participants, especially when we have clear structural reasoning.

Reducing Resistance: According to the "Law of Least Effort," the more energy-intensive a task is, the less likely it is to occur. If the resistance is too great, the difficulty of achieving our goals will also increase.

Another Metaphor for Market Behavior: The Trolley Problem

Imagine the market as a train, and this train is like a "killer" eager to "hunt." When we act in the fair value zone, both sides of the market are crowded with participants, making it difficult to predict which side it will choose to "hunt" more people. However, once the market chooses one side, the other side becomes the only option, making our decision-making simpler.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 0

What is Liquidity?

Liquidity refers to whether there are enough counterparties in the market to conduct trades. When we trade, we either consume liquidity or provide liquidity. If prices remain stable in a certain area (i.e., a balance zone) or cannot fluctuate smoothly, it is because buyers have failed to consume enough liquidity; conversely, if prices can fluctuate smoothly, it indicates that buyers have successfully consumed enough liquidity.

Limit Orders vs. Market Orders

Limit orders "add liquidity," while market orders are tools for executing trades and consuming that liquidity. Passive liquidity (limit orders) is usually more influential because limit orders often determine market structure, while aggressive market orders get absorbed at key points.

Why are limit orders more influential? Because when you execute a market order, you need to cross the bid-ask spread, which means you will immediately be in an unrealized loss position after placing the order.

What is the Spread?

The spread is the difference between the asset's buy price (ask price) and sell price (bid price). Market makers provide liquidity through the spread, meaning the price to buy an asset immediately is usually slightly higher than the market price, while the price to sell immediately is slightly lower than the market price.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 1

Assuming the current price of an asset is 10.00, and the asterisk represents each contract. If we want to buy immediately, there is no quote at 10.00 in the market because if there were, market makers would not be able to profit. Therefore, they set the ask liquidity slightly higher, for example, placing four contracts at 10.01 to capture this small difference.

If we decide to buy three contracts, we will transact at the price of 10.01. But what if we want to buy more, say 15 contracts? We would need to cross the spread until we find enough orders to complete the trade. Thus, the price would eventually be pushed to 10.03, as only at this price level is there enough contracts to meet our demand.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 2

Through this example, we can understand why limit orders are usually more influential. The impact of small-scale traders on prices can be negligible because they do not encounter significant slippage. However, if someone wants to buy 500 contracts and there is not enough liquidity nearby, they will have to cross a large spread, causing significant price fluctuations.

If traders choose to place orders in areas with ample liquidity, they can avoid significant slippage. So where is liquidity usually concentrated? The answer is above swing highs and below swing lows. This is because most technical analysis-based traders exhibit similar behavior when stop-losses are triggered, and these positions often become concentrated areas for stop-losses, making prices more likely to reverse at these levels.

So, are their stop-losses your entry points? Indeed.

Summary

  • Impatient buyers or sellers push prices through market orders (the active side), consuming liquidity.

  • More patient buyers or sellers prevent price fluctuations through limit orders (the passive side).

We can use a metaphor to describe this: market orders are like hammers, while limit orders are the floors or ceilings of a building. To break through a floor or ceiling, sufficient hammer force is needed.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 3

What happens when the floor is broken? Prices will quickly move to the next floor.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 4

Once prices reach the next floor, moving upward becomes easier because the ceiling has been broken, creating a "gap" that allows prices to fluctuate more easily in areas with scarce liquidity.

Understand the market like a puzzle, revealing the intrinsic logic of liquidity, spreads, and market fluctuations image 5

Liquidity cascades are a very effective way to make money because at this point, we are trading with those who are forced to trade, price-insensitive groups (e.g., traders being forcibly liquidated). But we need to be clear about what we are trading.

If you are trading liquidity premiums, this effect is usually very short-lived, lasting at most 10-15 seconds. In a cascading environment, this situation may change. In this case, you need to judge whether liquidity has fully recovered from the initial volatility.

The chain reaction of momentum shifts, while not as reliable as liquidity premiums, has stronger persistence (most people think they are trading liquidity premiums when they are actually trading this momentum effect).

The first method (liquidity premium) is more suitable for PNL attribution (i.e., analyzing the reasons for making money) and is the more ideal operational approach. The second method (momentum effect) can capture the core parts of large fluctuations but comes with greater volatility and looser risk control.

Overall, liquidity cascades lead to supply-demand imbalances as a large number of price-insensitive traders flood in, and the order book cannot withstand so many active traders. However, once the market stabilizes, prices will more easily return to those areas that failed to form sufficient trading volume due to rapid fluctuations.

After all, the market is a two-sided auction mechanism, and it often tests those low-volume areas for two reasons:

  • Such paths have less resistance;

  • The market seeks efficiency, testing these areas to see if anyone is willing to trade at these price levels.

The result is a "mechanical rebound" in the market, as the order book needs time to rebalance. At this point, only a small amount of trading volume is needed to drive price fluctuations. Once the market stabilizes, price movements will rely more on momentum, accompanied by higher volatility, but also capturing more profits.

Remember, high volatility often follows high volatility, and low volatility often follows low volatility, a phenomenon known as volatility clustering. Therefore, seize opportunities and adjust your risk management strategy based on each change in market conditions.

0

Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.

PoolX: Locked for new tokens.
APR up to 10%. Always on, always get airdrop.
Lock now!