5 Things Most Traders Don’t Know About How Prices Move in the Markets

Let me ask you a simple question…

How and why do prices move in the markets?

Most traders will give one of three answers:

1. Admit they don’t know.
2. Give a vague explanation about supply and demand.
3. Spout some imaginary nonsense or conspiracy theory.

The truth is, at least 99% of traders I meet (or see teaching online) don’t know how the markets actually work.

And that seems pretty crazy to me!

How can you be confident that you have a profitable trading approach, if you don’t know how and why prices move?

Imagine designing aeroplanes without understanding aerodynamics.

Imagine forecasting the weather without knowing meteorology.

You get the idea.

It’s because people lack this foundational knowledge that so many flawed trading methods become popular.

So, in today's piece, I'd like to share five important things most traders don't know about how and why prices move.

If you want a more in-depth understanding of this topic, ​read our full guide​ for a more detailed breakdown.

1. Types of orders in the markets

To understand how markets work and what causes price movements, you first need to understand the relationship and differences between two important types of orders.

Although there are many variations of orders, we can broadly group them into two categories:

• Market Order: transacts immediately at the best price
• Limit Order: transacts only at a specific price

We can think of market orders as being more aggressive; you want to execute the trade regardless of what price you get. Limit orders are more passive; you’re waiting to see if your order gets filled at your designated price. If it does, you transact at the price you wanted. If it doesn’t, your trade doesn’t get executed.

Most traders understand the practical difference between these order types for their own trading. But not enough traders understand why the relationship between these orders is so important for how the markets function. Let me explain...

2. How trades are executed

For a trade to be executed there are at least two parties involved: a buyer and a seller. You can't buy something without someone selling, and vice versa.

But how does this process actually work in the markets?

In basic terms, a trade takes place when a market order transacts against a limit order. If you click 'buy' in your trading platform and a market order is executed for you, it'll transact against a limit order.

Therefore, limit orders provide liquidity in the market, and participants who use them are known as 'liquidity providers'. Liquidity refers to how easily an asset can be bought or sold quickly at stable prices.

Participants using market orders are known as 'liquidity takers'. They’re transacting against limit orders, so they're taking liquidity out of the market.

This process of providing and taking liquidity dictates how prices move in the markets. Let's take a closer look...

3. How prices move

People often say prices move in the markets based on supply and demand, but that's an oversimplification. The reality is much more interesting than that!

From what I've explained so far, can you guess what we'd consider the supply or demand in the market to be?

If you're buying with a market order, the limit orders are the supply and you're the demand. If you're selling with a market order, the limit orders are the demand and you're the supply.

Let's think about what that means for price movements.

Limit orders are placed in the orderbook of the market. Market orders to buy will transact with the lowest priced ‘ask’ in the orderbook. Market orders to sell will transact with the highest priced ‘bid’ in the orderbook.

Imagine right now there are market orders to buy a total of 1000 units. If there are limit orders of at least 1000 units at the current price, the trades will be executed and the price won't need to move. There's enough supply at the current price.

However, if there are only 200 units of supply, it's not enough. The price will rise to find enough liquidity at higher prices for the market orders to transact with. In other words, there's more demand than supply, so the price has to rise.

If this is still unclear to you, or if you want to dive even deeper, ​check out my detailed guide​. By fully understanding what this means for the markets, you can transform the way you find trade opportunities.

4. Types of market activity

We can now define two important terms that help us assess market activity in a simple way:

• Liquidity refers to the limit orders in a market
• Volume refers to the market orders in a market

This broadly gives us the following quadrants:

1. Low volume, high liquidity
2. High volume, high liquidity
3. Low volume, low liquidity
4. High volume, low liquidity

In reality, volume and liquidity won't simply be high or low. Instead, they'll each be somewhere along a spectrum, and this will fluctuate over time.

But these simple categories allow us to interpret different market situations and types of price activity. We can understand what may be happening below the surface, and that may change the way identify opportunities. You can find examples of this in ​my detailed guide​.

So how can you view volume and liquidity?

5. How to see this on your charts

The process of limit orders being placed and market orders transacting against them is commonly referred to as order flow.

There are many ways to display order flow data, but the two main tools I focus on are the depth of market and footprint charts.

The depth of market (DoM) shows us the liquidity in the market. It's the orderbook. We can see the limit orders that are placed at different price levels to buy or sell, as you can see below.

The DoM is like the advertising board in the market. Participants are advertising how much they’re willing to buy or sell at different prices, waiting for someone to take the other side of the trade.

Then we have the footprint, which shows the completed transactions. These are the actual trades that happened when a market order transacted with a limit order.

In each footprint block, the left side shows the transactions where a market order sold against a limit order. The right side shows the transactions where a market order bought against a limit order. The numbers represent the volume of these transactions at each price level.

Being able to look under the hood of the markets and understand what's going on can provide you with amazing trading insights. What I've covered in this email is really just scratching the surface.

If you want to go further, start with my ​detailed guide​.

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