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Market Microstructure: An Extensive AnalysisI. Introduction Market microstructure, a specialized area within finance, explores the intricate mechanisms involved in trading within financial markets. It focuses on how trades occur, the interplay between prices and information, and how these interactions collectively shape market dynamics. Understanding market microstructure enables investors, traders, financial institutions, and regulatory bodies to comprehend the process of price formation, make informed trading decisions, design effective trading strategies, and develop sound financial regulations. II. Theoretical Foundations Three fundamental theories underpin market microstructure: The Efficient Market Hypothesis (EMH), the Random Walk Hypothesis, and the theory of Information Asymmetry. Each theory provides a unique perspective on the functioning of financial markets. Efficient Market Hypothesis (EMH): The EMH, introduced by Eugene Fama, posits that financial markets are "informationally efficient," with asset prices instantaneously reflecting all available information. According to the EMH, consistently outperforming the market is impossible without assuming additional risk, since every piece of information that could potentially affect the price of an asset is already factored into the current price. There are three forms of market efficiency according to the EMH: weak, semi-strong, and strong, each reflecting the extent of the efficiency. Random Walk Hypothesis: The Random Walk Hypothesis suggests that price changes in securities are independent and identically distributed, meaning that past movements or trends cannot predict future price movements. In essence, securities prices follow a 'random walk', making it futile to predict future prices based on historical data. Information Asymmetry: This theory points to the situation where one party has more or better information than another. In financial markets, information asymmetry creates a dynamic where informed traders (insiders) can potentially exploit their information advantage over uninformed traders, disrupting market efficiency. III. Role of Market Makers Market makers play a pivotal role in financial markets, facilitating transactions by constantly quoting bid (buy) and ask (sell) prices for financial instruments. Their constant presence in the markets helps maintain liquidity and market efficiency. Market makers are compensated for their services through the bid-ask spread - the difference between the bid price and the ask price. This spread represents the market maker's profit and compensates them for the risk they undertake in holding a particular security in their inventory, which might decrease in value. IV. Order Flow and Price Discovery Order flow, the process by which buy and sell orders are executed in the market, is integral to price discovery - the mechanism that determines the price of an asset in the marketplace. Analyzing order flow can provide valuable insights into trading activity and market sentiment. When a large order hits the market, it can significantly impact a security's price, creating price volatility. Understanding order flow is therefore essential for managing risk, providing liquidity, and effectively navigating the market. V. High-Frequency Trading (HFT) High-frequency trading (HFT) employs advanced algorithms to execute large volumes of trades in microseconds. HFT can improve market efficiency and liquidity by reducing bid-ask spreads, rapidly processing new information, and providing additional liquidity to the market. However, HFT also has potential drawbacks. Its speed can raise issues around fairness, with HFT firms potentially exploiting their speed advantage to the detriment of slower market participants. It may also increase market volatility and contribute to market instability, as evidenced by instances of 'flash crashes.' VI. The Impact of Information Flow Information plays a pivotal role in financial markets. Two categories of information that impact trading and investment decisions are public and private information. Public Information: This includes macroeconomic data, corporate earnings reports, policy changes, and other marketnews that are equally accessible to all market participants. When this information is released, markets adjust as participants process and respond to the new information, causing immediate and often significant price changes. Understanding the dynamics of how public information impacts price can provide traders with an edge in predicting and navigating market reactions. Private Information: This refers to non-public or unequally distributed information among market participants. Informed traders, who might have access to private information, can use it to their advantage, resulting in potential profits. However, this leads to information asymmetry, which can disrupt market efficiency and fairness as it creates an imbalance of knowledge among market participants. The impact of information flow on market prices is significant. Rapid adjustments to new information keep the markets efficient, but they also introduce volatility. Information asymmetry can lead to market distortions and manipulative practices like insider trading. Therefore, understanding the flow of information is key to comprehending market microstructure. VII. Market Microstructure Models Several market microstructure models have been developed to better understand the relationship between information asymmetry, price determination, and market participant interaction: The Sequential Trade Model: This model, also known as the "dealer model," posits a single dealer who trades with many customers. Dealers, who are assumed to be less informed than their customers, adjust their prices based on the order flow. For instance, an unexpected surge in buy orders would lead the dealer to infer that customers might have positive private information, and therefore, they increase the price to offset potential adverse selection risk. The Strategic Trade Model: This model focuses on traders who tactically time their trades to maximize their expected profit. They consider the potential impact of their trades on future prices and act accordingly. For instance, a trader with private information about a forthcoming price rise might initially trade smaller quantities to prevent any significant price impact that could reveal their information. The Market Making Model: In this model, multiple market makers compete for customer orders, and prices are determined based on this competitive dynamic. The market-making model allows for a more realistic market scenario where competition, rather than a single monopoly dealer, drives price adjustments. These models offer valuable insights into the complex process of trading and price formation in financial markets. VIII. Regulatory Implications Understanding market microstructure is crucial for financial market regulators. They must ensure that markets remain fair and efficient while also being conducive to innovation and competitive market making. With the growing complexity and speed of financial markets—especially with the rise of algorithmic and high-frequency trading—regulators face the challenge of managing the delicate balance between allowing market innovation and preventing practices that might lead to market instability or unfair advantages. IX. Future Directions As technology continues to transform financial markets, market microstructure's importance in comprehending these changes cannot be overstated. The rise of digital assets like cryptocurrencies, the growing use of machine learning and artificial intelligence in trading, and the proliferation of decentralized finance (DeFi) platforms all necessitate a deep understanding of market microstructure. New theoretical and empirical models will likely emerge to explain phenomena that are not well understood today, further deepening our understanding of market dynamics. Similarly, the regulatory landscape will continue to evolve in response to these changes, making the study of market microstructure crucial for informed policy-making. X. Conclusion Market microstructure is a crucial field in finance that examines the intricacies of trading in financial markets. Understanding how market makers function, the strategies of high-frequency traders, the impacts of information asymmetry, and how asset prices are formed is essential for participants across the financial landscape. As technological advancements continue to transform the financial industry, insights offered by market microstructure will be of vital importance in navigating these changes. The field will continue to grow in relevance, contributing to more efficient, fair, and resilient financial markets. I hope that you find this information valuable, if you have any questions feel free to drop them in the comments. Enjoy!
BITSTAMP:BTCUSDEducation
by BiggWigg
The Secrets to Forex & The Ecosystem TycoonThis article will cover technicals (finally). It is part 8 in the series, and the first of two parts on technicals. It is strongly recommended that you read the others in order for full value. This one is long and more complicated than the others, because you deserve it. Part 1: Raytheon's Military-grade Market Trader There are two problems with selecting technicals in trading. 1. Hard to understand the logic/math guiding the design of many indicators 2. Too many indicators available to choose from without wasting substantial time and cognitive resources On one end of the spectrum, we have bellhop shit, like simple moving averages. On the other hand, we have Ehler's masterpieces. I probably should have given John Ehlers credit at the beginning of this series, because his work was very influential on my intra-day trading theories, in particular. The old man was working on UFO technology at Raytheon before most of us were born, giving you a pretty good idea of the sheer intellectual value he brought to the technical ideaspace. He traded one game of lights and color for another. And I strongly recommend googling and reading through his theory in conjunction with this article. However, the bigger concern isn't the complexity of some indicators, like his, but the volume of choice available. There are, by my abrasive estimation, over 22,000 indicators publically available on the internet. It is a fruitless task to try to bruteforce test them all (unless you have a background in neural net programming). It is far more useful, for your cognitive and time-limited resources, to develop theories or descriptive plans for trading, and then find indicators to fit or fulfill those ideas. Trust me, I learned my lesson on this one. Useful application of your time, and your thinking resources, is really important in this business because everyone is always in a state of researching and learning (to improve their edge). It's like a sport, people get better over time, and you have limited training time in the offseason. Which means it will be harder for you to make money if you aren't getting better. More in the article after next on the hellscape that is intra-day trading. For now, let's introduce a technical price action theory. Just because school has been closed for months doesn't mean you still can't get lectured. Though you can skip to Part 6 if your people just invented fire. Part 2: The 2600 year old Libertarian Tao 57: Therefore a sage has said, 'I will do nothing of purpose, and the people will be transformed of themselves; I will be fond of keeping still, and the people will of themselves become correct. I will take no trouble about it, and the people will of themselves become rich; I will manifest no ambition, and the people will of themselves attain to the primitive simplicity.' The basic libertarian claim: 'that something invisible guides the behavior of actors,' is also the fundamental axiom of Adam Smith's philosophical work on political economy. This little wisdom is thousands of years old, and was likely inspired by our ancestors observations of the natural world. There is a real life analogy to this that I want to introduce... so we don't have to sift through all 22,000 indicators only to settle on just a few. Let's talk about the process of pattern discovery. Part 3: The Auric Pattern Machine The flintstones of the world did not have the internet, schools, or the mainstream media to give them the truths of the world. They could only understand, survive, and predict our reality by watching patterns of nature enfold all around them. The system of the forest environment, of the river, of the mountain. These patterns had profound influences on the thinking of ancient philosophers. They knew that despite the influence of weather, natural disasters, or human interaction, these granular earth systems would persist. They were resilient, and many early humans worshiped the particularly impressive examples of these eras. The examples were transformed into symbols of gods, the divine, or spiritual ideals. They became the first memes. The mountain range of the gods, the forest of the giants, the rivers of the spirits. They created identifiable gods to represent them, and made them offerings out of perceived necessity and respect. We laugh now, but it is certainly better than the offerings we make to the "triangles" we worship today. What made these systems powerful were their ability to last, to appear timeless, at least to humans. Many of these early philosophers correctly identified the underlying factor that gave them these qualities. It's the ecosystem factor. All things that last are ecosystems. The ecosystem entity IS the invisible hand. Ecosystems allow extremes, they allow opposites, they allow emergence, they allow reduction, they allow development... they are machines that produce novel and recurring patterns. All they require is everything to be in balance at any given time or conversely, subject to a universal logic. A type of central tendency that binds all their behaviors to 'logos' (the balancing language). The logic of the mountain is cold and jagged. The logic of the river is water and flowing. It sounds goofy. Like some Avatar or New Age mineral oil. But the market is no different. It is bound by the logos of greed and delusion. And that's where we come in, the Bernie Sanders's and Bernie Madoff's of the world. This should all sound somewhat familiar to you. Like you have heard it before (before my articles), or seen something similar in a movie or whatever. The message comes from many different sources. Part 4: Energy/Cash Flow There are many actors in the market ecosystem, with different wants and interests and capabilities. Young and old, male and female, stupid and intelligent, rich and poor, winners and losers. And thanks to the transition of time and the power of big pharma, one person can be all of those things at some point. But the central logic binds them all together, it's the most common divisor. And unlike the case of the mountain ecosystem, the patterns the market ecosystem produces can be visualized by something more simplified and visualized, a single value called price. The market ecosystem has many "animals" and "plants" impacting that price value as they subject themselves to the logic of greed. You are not one of these animals, you do not have the market power or influence. You are playing someone elses market. In other words, your nutrient and energy flow is too small to make a big impact, you can only depend on the others. Just like a single tiny bug would have little impact on the behavior of the whole forest compared to a tree or a bear. Right now, you are like an honorary member of 'antstreetbets.' Trade well, and you just might get to see your Queen's exposed carapace. Part 5: Stillness So how do you do measure the flows of the bigger influences? First you have to be as still as possible, and recognize your place. Though you have no real impact in the natural ecosystem, you can cloud or distort the estimation of it via your foreign influence, by misunderstanding your position. In market contexts, I mean that your assumptions on market patterns can mask the ACTUAL patterns that exist in the market, you have to look at what the major influences in the ecosystem are (the trees, the bears). This is true for any market: what consumes the most energy, where are the nutrient flows? In a way, the ecosystem is just another market for energy and nutrient trading. Now, you might be munching on your grayons wondering when the strange analogy is going to end. And that's why I made you the bug in this example. Part 6: A Bugslife So we need only look to the wealthiest groups in markets to judge who has the major influences (cash flow is key). What patterns do they create? Fortunately, many of these influential animals use similar technicals indicators (thinking strategies) to understand their ecosystem (and try to benefit from it). Though you will never have the same impact even if you copy these thinking strategies, you can still benefit in your small way by mimicking the successful survivors and tycoons of your local ecosystem. If markets are ecosystems, and ecosystem persist, than how do we, the bug-like trader, take advantage of this 'prediction' or 'certainty?' It's actually quite simple, we try to find the balance, the central tendency, the logic, and we attach a value to it... when the sum of the behaviors of all the animals start to move far from that 'value' in the short run, we can correctly guess that the ecosystem, in its ability to demand persistence, will find some means (via its invisible hands) to return to the mean. This gives us a good clue at what indicators we need to be looking for. NOTE: The technical addition is a major player overall, but only because it's simple to read, it clearly lays out the operational environment, and it allows fast decision making. It meets the Boydian requirements to be theoretically competitive, namely the concept of cycle time management, which will be further covered in the intra-day article. Remember that the 'value' of the center of price gravity is not necessarily a specific price, it may be a range of prices. It may be a fuzzy uncertainty that orbits a major round number. And do keep in mind that this resilient value is comprehensive and includes factors from prior articles (fundamental, seasonals, interest, etc) in its overall calculation. Part 7: Tycoon It's a lot of words to get at something simple, but the key takeaway is how timeless and pervasive this overall concept is. It's integral to nature, to complex systems, to our market system. It was true in the beginning, it is true today, and it will be true in the end. That's why you bet on it, or in risk management terms, you wouldn't want to bet against it. The goal is to own some stock, no matter how small, in the fundamental logos of the ecosystem, or at least ride the coattails of the owners. That's what a tycoon is. Someone that owns a fundamental component of the market/economy ecosystem. Someone at the center, where everything in the periphery has to flow toward him at some point. When you understand it, you can direct yourself towards indicators and research that align with it. Whether they are new or old, you can more easily sift through the 20K+ available with this evaluation basis. Part 8: Operationalizing Terms The Ecosystem system is a recurring scheme that involves the center of price gravity , extremes attached to that center, the patterns that flow between those two states, and the speed/timing of those patterns. For long-term trading, you want to: find the center, then calculate the extremes, then look for patterns flowing between those two states, and finally timing-through-seasonality. (For intra-day trading, seasonality will be substituted with Boydian time cycle management) While the first two are technically sufficient for risk management, the better you are are at recognizing the flow patterns and timing-through-seasonality, the lower your necessary account size and the higher the probability of your desirable rate of return, or consequently, favorable market access. IE, if 105-106 is the center of price gravity on UJ, but price is currently at 109-110, which is the extreme calculated, you would consider either: 1. shorting, 2. closing a long, 3. or not entering a new long at that extreme level. However, price action may sit for an extended period in a distribution regime, increasing your exposure to volatility and capital opportunity cost over time if you choose option 1. Terms: CPG: Center of Price Gravity (The center of the ecosystem, resilient value, the mean reversion point) EX: Extreme (The furthest edge the ecosystem allows without collapsing. What Ehlers calls the "amplitude") FLOW: Pattern Flow between States (Flow is the sum total influence of patterns, in other words, a weakening market or strengthening market. For instance, weakening is measured by many different patterns showing short or selling predictions/setups. So the FLOW is the change between these states, like the Security vs Fear transitions; FLOW also occurs as accumulation momentum in-between compression regimes. While it is true that all traders are greedy; security and fear are the primary distinctions that allow FLOW to occur. They both contain greedy psychological underpinnings.) SEA: Seasonality Timing (Open interest, liquidity behavior, the will of the wealthy. The cyclical or Samsara market nature.) Part 9: Technical List Major Round Numbers A big psychological supplement, measured in increments of 100 pips. Important that the round level has a 25+/- Pip attractor, so keep that in mind when adding round numbers to your measurement. It is easier to remember round numbers and they are more often repeated/identified in financial news (Bloomberg feeds and Reuters feeds, etc) from sources used by commercial/institutions/major funds. As far as this numerology is concerned, always remember to checkem. Random Walk A major identifier of pattern flow. This indicator is the purest example that the market is, infact, very inefficient for meaningful periods of time. It's inefficient because it should remain near or at the . Historical Models/Seasonality In light of VaR limitations, I recommend using historical models instead, simply because they offer some predictive explanation and a visual guide. Like VaR they should not be used or expected to measure or anticipate black swans. Many of these are paywalled, but you can basic versions via google. Since it is a major source of seasonality assessment, this is strongly recommended. Sometimes they are called 'historical capital flows.' Most give a daily open or close level, and a minimum and maximum price level for the day. These models are not useful for intra-day trading, but become more useful the longer-term your position is planned to be... keep that in mind. If you have a programming/statistics background, there is significant opportunity in developing historical models for retail and NNW clients (non-rich people). The granularity of historical models tends to be limited, like that of seasonal values (which tend to be multi-daily at best, but usually weekly or monthly). Find a way to make it intra-daily or even per session and you could print some serious money. How do I know this? Because it would be my money paying you. Major Moving Averages The most important indicator for determining CPG due to the 'market players making markets' rule. HAS TO BE THESE VALUES: 50/100/200 at 1h, the 50/100/200 at 4h, and the 50 or 55/100/200 at D; those are the most important that every trader should use. These are integral to determining , mainly because of their psychological value and relevancy, and when combined with round numbers, offer the strongest psychological technical representation in the market outside of seasonality and COT sentiment. They are usually insufficient for since they are lagging (from high periods), but serve as gravitational levels individually, and also when viewed as compositional. That is, the full range between the highest and lowest can offer a likely zone for current . You can refine that zone further with round numbers, VWAP, a regression, and so on. ADR/ATR The most important indicator for determining extremes; it is loosely derived from VaR and historical modelling ideals; but exists in many different forms and is often graphed to the daily timeframe. It is additionally powerful in a session format, that is, as an NYC session ATR and so on. You should at least be using ATR to calculate daily extremes (ADR), weekly extremes, and monthly extremes. These levels effectively represent the pip range possibility of any pair. Alternatively, it demonstrates the total range a pair can move based on the traditional influence of market supply and demand. It's like knowing 'how much' money is flowing through the pair, which is important because there is a limited amount of money available and willing to be used for trading, thus implying a degree of certainty in the limit of price action (its range). You can think of this cash like energy/nutrient flows; there is a limited amount contained within an ecosystem (sans supply from the Sun) so you know that the ecosystem can only grow so large based on the limited supply of energy available for transfer. ATR+ADR is one of the best measures of volatility. It's the closest thing to true VOLUME you will get without privileged access to prime brokers or settlements providers like the CLS Group. What this range measurement enables is a PREDICTION with DECENT CERTAINTY of how far the price could move within a day, within a week, and within a month. Remember, artifacts of certainty are highly desirable in risk management because so much of trading is based on delusion. It is also an approximation of total influence on the market that an event can cause. Regression This is more effective than a basic channel. Use this for additional visualization guidance; can help determine the angular change in price, a useful measure for detecting the development of new patterns, similar to VWAP. (especially if you have many iterations of regressions running, visualizing shifts in 'angular frequency') VWAP A resource heavy computation, look for weekly and daily VWAPs. I will talk more about VWAPs in the intra-day section, because they have important overlap with session psychology. This is one of the most powerful measuring tools to reach a precise price value, though it is detached from the psychological influences more common to major moving averages or round numbers. You should generally be wary of a precise value, like 133.845 and instead settle for a range or zone: 133.80-134.00. This is to insure that edge remains abundant within your strategy. Market Profile Similar to the other tools, but can be structured to view just the prior day, current day, prior week, etc; it's really just another visualization tool for VaR, which can help you pinpoint likely order areas. That said, it's okay to swipe left on this one. Pivots Pivot points are technically ATR related but the visualization can help. The opening level of the day/week/month in particular; they can be used to find opening zones which often act as return targets across uncertain sessions. You need to use common calculation with pivots for psychological value. No Waddah Attar Pivots, unfortunately, because institutions aren't looking at those. Laguerre/Sine This is not an indicator in itself, but a way for other indicators to calculate or process some market information, a filter. Technically also an Elhers invention. If you have the option to use Laguerre or Sine based filters/calculations, then I strongly recommend it. The Laguerre method fits the ecosystem approach by modeling the market center of price gravity (what they call attraction zones) with a root-finding algorithm (at least when represented by a single indicator). I have found through substantial testing that Laguerre is one of the more accurate filters in forex for . Sine is cycle based. You can find sine based indicators on TV. Turns out it's not hip to be square. Ehlers Cycle Capture This includes a basket of indicators. Somewhat similar in concept to Boyd and Shewhart cycle theories, which we will discuss in the intra-day article; both inspired by radio science and physics. Ehlers has a complicated explanation on his reasoning behind its technical utility, involving what he calls Maximum Entropy Spectral Analysis. While I am no expert on wave equation science or radio engineering (not enough money in it), rest assured, his MESA theory is nearly synonymous with the concept of that I explained earlier. It covers most of , unlike , which needs many indicators unfortunately. You might think of this as the ultimate trend following tool. But remember, the is 'a pattern of patterns.' In some cases, the trend may be very disjointed, a series of HHs and LLs could constitute a trend of 'increasing momentum and volatility.' You will need Random Walk and a Regression to smooth those issues over. Currency Correlation & Strength Very comprehensive, but can be hard to read. I will talk more about this for the intra-day article. Suffice to say, instead of comparing EUR pairs to AUD pairs, you should compare AUD pairs to the smoothed average AUD position (looking for an AUD pair that is operating well outside the average behavior zone for other AUD pairs at the time); this helps you identify events through what a normie trader would call arbitrage. Especially useful for taking profit. There are many indicators that can do this. Be warned though, sometimes these events are just the initial move inspired by a major sentiment shift in fundamental or geopolitical event volatility. This risk can be overcome with currency options, which are as underrated as carry conditions. I will also talk about them in one of the last articles. Bollinger It is very important that you only recognize the utility of bollinger on WEEKLY and DAILY timeframes and at a 20 period calculation. If price action breaks the bands on the daily period, you will want to wait for the start of the next week to consider that event valid. That is, valid for entering a position or closing a position. This is the most useful setup for bollinger. The weekly period bollinger allows you to see the long-term bias. Is it shifting? Though major moving averages should be your first preference to check. On-Balance Volume Useful for finding 'fake' tops and bottoms. Though I generally do not advocate double-top or double-bot style trading, it can help show exhaustion and the likely shift of from accumulation momentum into a distribution regime. You will want to use this measurement on intra-day extremes. That is, comparing two moves that happened within the same day, otherwise it will not work correctly. Do not compare two extremes within the same week or across multiple days with this tool. You can only use OBV otherwise on assets with real volume available. Part 10: Caution And remember, for the very long-term traders. The closest approximation to true value (the purest ) when you operate at the 'classical mechanics' level is the relative strength of your interest rate and the broader economic profile of the country printing the currency. Technicals are just a quantum picture that offer opportunity in chaos. Though they help measure the entire ecosystem, you can't get too distracted by just the electrons. For instance, questions like these will require both vantage points: Are the limits of the extremes expanding or shrinking (thereby affecting the risk profile)? Does the pandemic push the down 600 pips or 900? Technicals can give you the routes, but not the solution to the 'if' component of the question. Part 11: The Delonge Defense This list isn't comprehensive, and in full disclosure, I will note that my own systems use a few commercial and novel design technicals that I can't share here. Mad about that? Good. I live by the competitive edge and die by the edge, just like any other market player. The above, however, covers key areas you need to support at minimum and will be enough for many traders to go fulltime (when used in confluence with the other factors like seasonality, carry, fundamentals, etc). The biggest takeaway is the need to start with theory before exploring technicals. This ecosystem explanation offered will cover most of your risk needs as far as forex technicals are concerned. Perhaps you can expand it, or find something even better. I doubt it, but a gentlemen puts up with a ladies fictions. I will talk about what to avoid in the technical universe in the next article. That will probably help more for those of you that are lost and confused Joepedos. Part 12: The Ride Never Ends With proper risk management, your 'stillness' (your observation) in the market can reveal the natural center of gravity, the logic that forms the ecosystem (your theory) and reveals the 'amusement park' all around you. The tycoon stands at the center of this, allowing the flow to come to him (the strategy and technical system). With relative ease he can access this flow, due to its abundance, fulfilling the logic of greed he is bound to (the market psychology). Ideally, the ride never ends, the ferris wheel keeps spinning, the park is open 24/7 365, every decade, every century. That's it. And by the way, when you make it, I expect a discount on my ticket fee.
by CountofCoins
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