Unraveling the Market’s Mechanics: A Trader’s Philosophy

Understanding the Inner Workings of Markets to Forge a Trading Strategy

Understanding Market Philosophy

What do I believe about markets? I feel every trader should harbor a core philosophy about how markets operate; this is the framework upon which your strategies and models should be built. Without this compass, it's difficult to discern the specific traits of the market you're seeking to leverage, rendering you susceptible to the markets' capricious tendencies.

The Essence of Markets

First, let's dissect the basic fundamentals of markets. At their core, markets are merely platforms where buyers and sellers convene to exchange goods or services. If both parties concur on a price, the trade is executed. In today's digital age, this process has been accelerated to near-instantaneous speeds—especially in liquid markets where finding willing buyers or sellers is seldom an issue.

Naturally, there exist illiquid markets where ready liquidity is scarce, posing a challenge for trading activities. However, we're not focusing on these anomalies in this particular discussion.

The Trader's Edge

Given every transaction involves a buyer and a seller, it’s crucial to ask yourself: why would someone agree to trade with you at a price that benefits you more than them? What unique advantage equips you to navigate this arena successfully over the long haul?

In my observation, at present, you are compensated in the market for offering a specific service. Analogously, a mechanic gets paid for their expertise—the higher their skill level, the greater their earning potential. So, what service are you rendering when you engage in trade?

Trading as a Service

Consider the scenario of a breakout. When you buy into a breakout, you're betting on the trend to prolong enough for you to turn a profit. Not necessarily on this specific trend, but over the cumulative impact of all trends you engage with.

But if we view this action from a service-oriented perspective, what service are we extending to the market? In my opinion, we contribute to the price discovery process. By buying, you increase the asset's price, helping the market climb higher and earning profits for all stakeholders. When you sell, you're essentially being compensated for this contribution.

You might object by saying your trading volume isn't substantial enough to influence the market significantly. This might be true in isolation, but in the grand scheme of things, every trader's activity contributes to the overall market dynamics. You and your fellow traders accepting the directional risk and consistently bidding at escalating levels play a crucial role in this mechanism. You stand to profit from this service if you can align your actions strategically with the market's overall trajectory.

However, simply assuming risk doesn't guarantee immediate returns; it's crucial that the risk is undertaken judiciously and strategically. Owning a coffee shop that's been underperforming for years won't automatically turn a profit unless you implement effective strategies to reverse its fortunes. Similarly, in trading, your reward hinges on your ability to align your actions with the market's overarching intent.

Market Making and Its Relevance

Market making provides a more immediate feedback loop from the market. As a market maker, you offer liquidity to the market, thereby narrowing the spreads and reducing trading costs. This is an explicit service you provide to the market.

You might assume directional risk, especially with certain cryptocurrencies that can't be borrowed or don't offer futures contracts to short, or you could adopt delta-neutral market making strategies. Although these approaches still involve risk, it isn't as direct as assuming directional risk. Nonetheless, the intricacies of market making warrant a separate discussion in a future article.