Understanding the basic principles in how the markets operate will give your trading an edge. Some people mistakenly believe that trading is based on complete random luck.
While it may be true that there’s always an element of chance, prices can only behave within defined boundaries. There are only three directions that prices can move; up, down and sideways.
Whenever you take a trading position there is usually a 50/50 probability that prices will trend in your favour. That said, if you understand the root mechanics of how the markets behave it’s possible to increase your odds at finding winning trades.
The main thing that distinguishes professional traders from amateurs is that the pros have figured out a system that increases the odds of making consistent profit. The mere fact that some traders can have an edge and win more than 50% of their trades shows that not every market condition is a 50/50 probability.
Smart traders actually trade less and look for quality over quantity. In other words, they only put money on the line for higher probability trades. Having patience and knowing market behaviour is the secret ingredient of the pros.
Price discovery is the midpoint between two opposing forces of buyers and sellers. Since the markets deal with movement, it’s possible to apply Newton’s three laws of motion to your trades.
Law #1: Inertia
Every body persists in its state of being at rest or of moving uniformly straight forward, except insofar as it is compelled to change its state by force impressed.
This law applies to periods of consolidation within the markets. It’s a period of low volatility and sideways price action. Most of the trading volume that happens in this restful period of the markets comes from high frequency algorithms that scalp small price movements.
Unless running an automated trading bot it’s best to be patient and wait for a clear trend to present itself.
Law #2: Momentum
The change of momentum of a body is proportional to the impulse impressed on the body, and happens along the straight line on which that impulse is impressed.
Momentum impulses usually happen after periods of stable consolidation. Strong momentum can occur when prices push past a range bound market.
Large sized orders can lead to a chain reaction of momentum. Orders that break through support or resistance can trigger stop orders, liquidate leveraged trades and cause a rush of traders to jump into the markets.
Price momentum appears as large green/red spikes on the charts. Initial impulses that happen at key levels can lead to much larger trends. The key is to catch trends early and ride momentum.
Law #3: Counterforce
To every action there is an equal and opposite reaction.
Price momentum is often countered with an equal pull in the opposite direction. If you throw a ball into the air, eventually the force of gravity will pull the ball back down.
Price spikes are generally followed by a period of retracement in the opposite direction. Should a trend become exaggerated then one can expect a price counter reaction of equal force.
Momentum and counterforce create periods of high volatility, which is the perfect storm for good traders to make money. The price swings eventually get smaller until equilibrium is achieved through inertia, then the cycle repeats itself.