Financial markets are actually incredibly efficient.

Before you stone me for heresy, let me explain.

Typically, the phrase “Efficient Markets” carries the connotation that markets are efficient at the valuation of assets. This is laughable and categorically not the case. But there is something that markets are very efficient at: Seeking out liquidity. In this article, I define “liquidity” purely as “the facilitation of trade”, though things like volume and money flow also usually accompany high liquidity situations.

The markets are a gigantic mosh-pit auction. There are traders, both carbon- and silicon-based, constantly watching the same stream of prices, making judgments about the value of assets compared to the current pricing, and either making trades or sitting out. Some of these traders have a focus timeframe of a few seconds, some have a timeframe of years or more, and then there’s everyone in between. Any or all of them can become active or withdraw from activity at any time, with no way to know when any of this might occur. These facts lead to the conclusion that we cannot know what is going to happen next in the markets, we can only guess (though sometimes just a guess is good enough).

But what can we know? We can know with absolute certainty the following things:

1. If even one trader holding an instrument is willing to offer it lower than the current ask price, then the price will drop. This is true tick-by-tick, and the sum of the individual ticks results in overall price movement. If no traders are willing (or forced) to offer lower, then price WILL NOT drop.

2. If even one trader wanting an instrument is willing to pay more for it than the current bid price, then the price will rise. This is true tick-by-tick, and the sum of the individual ticks results in overall price movement. If no traders are willing (or forced) to bid higher, then price WILL NOT rise.

3. Market makers, specialists and those with seats on the exchanges make money when they do volume. The market system is structured to reward the facilitation of trade–the pursuit of liquidity.

Knowing these things, the secret of what moves the markets is revealed! Here it is:

Anything that impels a trader to make a trade moves the markets.

Thank you, Captain Obvious. But it is true, and it carries a subtle implication: because anything can impel traders to trade at any time, any one parameter that is correlated with market movement can become uncorrelated at any time. Translation–the market can and will move however the hell it wants to, whether or not it “should”. When trying to understand forces that “should” move prices, remember this to avoid losing your money and your mind when things go bananas and liquidity is found at retarded price levels, both high and low. The key is to recognize that these liquidity-seeking movements will happen, both rational and irrational, and to anticipate or react to them.

Liquidity can be either forced or opportunistic. Losing trades are usually forced, either out of fear of loss (or of taking an even larger loss) or greed (not wanting to miss out and entering on extremes in the wrong direction). Winning trades are usually opportunistic, taking the other side of the losing trades. This is the mechanism that allows money to flow from the weak hands to the strong hands.

Liquidity can also be either active or passive. Active liquidity is known and in the market, while passive liquidity is waiting to act on the sidelines. Active liquidity can be used to the advantage of market insiders; passive liquidity is uncharted and more ‘random’, especially liquidity that is outside the markets rather than inside (in the form of a held position).

Here is an example of each liquidity combination:

Forced Active: Price trades through a trader’s stop order, exiting his position at a loss. It is forced because price movement has compelled the action, and it is active because his order was already in the market.

Opportunistic Active: A stock gaps down, filling a trader’s buy-limit order that was placed below the market when it was created. It is opportunistic because the trader is theoretically buying value, and it is active because the order was already in the market, waiting to be filled.

Forced Passive: An panicked investor dumps his shares just after the market open because of adverse news that came out overnight. It is forced because the investor wants to exit at any price to stop the pain. It is passive because his intention to sell was not in the market until the moment came and he reacted. This could also reflect a shoot-from-the-hip trader chasing the end of a move to relieve the pain of missing out.

Opportunistic Passive: The market gaps up huge on stupid news. An astute trader sees this, and reacts by selling ‘em all they’ll take, betting that the price will fall back down. The liquidity was opportunistic, because the trader reacted to a favorable situation that presented itself. It was passive because it was not in the market or planned beforehand.

In your own trading, examine your strategies and determine where in the spectrum of liquidity your trades fall. Remember that the markets chase liquidity with ruthless efficiency, and other traders may be willing (or forced) to buy or sell at levels that are favorable or adverse to your position. Anticipating the forced trades and taking the other side, combined with recognizing opportunistic situations is the recipe to bank coin.

More on this to come…