What Causes Markets To Change Direction?

When looking at the markets, many traders look at lagging indicators for a signal that the market is changing in direction or to confirm that the main thrust of the market will persist. These conventional indicators quickly lose their edge as the institutions (mainly through algorithms) identify these common patterns and take action to move the market to nullify, or take the other side, of these trades causing those traders to lose.

In order for a trader to maintain profitability, she must have an edge. In the futures market, this becomes even more critical as leverage and the fact that trading futures is a net zero sum game makes it very challenging to maintain an edge if a trader is using the same strategies as everyone else.

Dynamics of the Market

To make this concept simple, let’s think about two immutable laws of market dynamics.

Buy and Sell Transactions

First, in any buying and selling transaction, there have to be two parties in order for it to materialize. A buyer will buy based on a perception of value, but will need to find a seller that has the opposite view of the exact same item or financial instrument. This could be for a futures contract, a stock or even a house for that matter.

Supply and Demand

The next factor is the concept of supply (large amounts of unfilled sell orders) and demand (large amounts of unfilled buy orders). When sellers are largely depleted, demand will take over and change the trajectory of the market. This works exactly the same on the buy side of this equation.

Another way to look at this concept is through the law of inertia. Inertia is the tendency of an object to stay in motion, which in the markets is referred to as a trend or momentum. Yes, trends tend to persist, just like objects in motion. However, the momentum will slow and reverse when it is met with an unbalanced force, or as Galileo discovered, it was friction that caused objects to change direction. In the markets, the reason markets turn is because of the shift in the Supply and demand equation.

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