On Wall Street there are many, so called, pundits that get paid a lot of money to forecast the next direction of the stock market. They use complicated formulas measuring the output of the economy, current and future interest rate projections, along with some conventional market theories. All told, their track record is not very good. Some pundits just stick to their bearish leanings until they’re ultimately proven right, at which point they proclaim how smart they are to their many acolytes. The same is true for the Pollyannaish gurus who are unrelenting in their bullish view of the stock market. These folks are right more often than their somber counterparts, as the market tends to spend more time rising than it does falling.
In Essence, what many of the pundits try to do is figure out when trends are going to change. For many this is very challenging. In fact, the conventional wisdom on Wall Street is that it’s impossible to pick tops and bottoms. And it is, if you don’t understand the laws of inertia. Simply, 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 constant shift in the Supply and demand equation.
Put another way, an uptrend will persist until all the buy orders are filled and an overwhelming amount of unfilled sell orders are found. It is impossible for the market to move higher unless all the sell orders can be matched. We can unequivocally make this statement because in any free market a transaction cannot happen unless there are two parties (the buyer and the seller) that agree upon a price. The same holds true when the market is falling.
Understanding this concept helps traders understand where to buy or sell, but also and more importantly helps traders identify how far the market can travel in the opposite direction so they can get paid.
Last week I took a trade in the ES (E-mini S&P 500) futures using these simple concepts. In the first chart, we can see a demand zone which represents a pocket of unfilled orders. The laws of physics applied here dictate that price will stop falling and turn higher at this zone. This presented a low risk buying opportunity.
That being the case, I placed a buy limit order at the top line and a stop 2 ticks below the lower line of the zone in case it didn’t hold. In order for the buy limit order to be filled I needed the ES to drop. The faster the drop the better because the velocity of the move would create a supply zone which, in turn, would leave enough room to the upside for a reasonable profit. In the picture below we see that price indeed fell sharply creating a reasonable distance between the entry and the new supply. Inertia is now in play again. If the unfilled buy orders (demand zone) will turn prices higher, how high will they go? Until they meet a large amount of sell orders, would be the correct answer.
If that is indeed the case, then the profit target has to be before the ES turns down, in this case it was at 1880 which is depicted in the next chart.
As we can see, this particular trade worked because the ES rallied off the demand and traveled back up to the supply before turning down. Not all trades will work as we all know. That’s because, unlike physics, the markets aren’t an exact science. The point here is that if we apply science versus emotion we can increase the probabilities of success. And yes, we can start anticipating market turns before they happen with a high degree of accuracy using simple laws of physics. Please don’t misinterpret this as trading being as easy as this. It’s actually quite challenging if you don’t have the right rules and the self-control to follow them, but it does help to keep it as simple as following the basic laws of inertia using supply and demand.
Until next time, I hope everyone has a great week.