Price is fundamental

Bhav Baghwan Hai

The fundamental principle of all trading activity is the Price. If there is no price, no transactions can ever exist. Every transaction can exist only at the intersection of price. Even if there are ginormous buying and selling interests, if they do not interact and come to an agreement on Price, none of the transactions can come to exist. To wit, Price is the particle on which the entire financial system is based on.

As marvelously put forth by above (mainly) Gujarati saying, Price is the God and everything else.

Price charts are a simple representation of accepted price at any point of time.

There are many methods of looking and analyzing prices, however we will concentrate on two important and critical aspects of price.

1. Auction Theory
2. Patterns

Auction Theory

Every market is in effect an auction by buyers and sellers. More the buyers’ demand for the product, higher will be the consequent prices. More the sellers for the particular product, lesser will be the price of the product.

Therefore every price level is equilibrium of the price for a ‘significant’ number of people at that price level. The reason it is ‘significant’ is that at any price point not all the players in the market will be active on either side, but at a particular level only people attracted to buy or sell at that price point would be active. Hence, a subset of market will always discover the price and hence may not form the equilibrium for the entire market.

This results in price trying to find its balance with the changing circumstances – fundamentals, or technical or new flows / outflows. The price keeps moving from one level of sub-set equilibrium to other, until it reaches (i.e. goes up or down) until equilibrium for larger and larger groups are formed. Once the maximum majority of the players discover on the price, the price is expected to hover around these levels – with minor volatility – until new factors and catalysts come into effect.

Further more these equilibrium points so discovered are critical levels of price for the product as it indicates the general acceptance of majority of the players.

Strategy: As traders, we try to exploit these moves between the equilibrium and try and profit from it.  As we know the price points with maximum acceptance is crucial we either trade with that point as support or resistance. Since, the acceptance rapidly decreases or increases if a price point is broker up or down (respectively), we can also try and trade a fade out of the price move.

Pros: This is a very efficient strategy when price of the product is ranged and no new demand shock or supply shock is expected. For instance, Crude oil’s demand and supply are roughly well estimated. There are few ‘shocks’ that can move the product prices far out of the equilibrium. If the prices moves too far higher, it impedes the demand and demand growth which in turn brings the product back to consumable levels i.e. buyer’s acceptance levels. Similarly, if the price drops too low or below viable levels, the cartels can cut off supplies, leading to a supply shock and rising the prices to the seller’s acceptance levels.

Cons: This is not a very efficient strategy when the price of the product has a very large variables. This theory will not work in extreme cases where the fundamental equilibrium itself needs to be changed after a massive fundamental shift. For instance, a larger loss, or drug discovery approval or declaring bankruptcy or some understatement or accounting frauds etc can fundamentally change the value perspective of the company. In such an instance the auction theory will hold effect – but from the perspective of the trader, the market will try and discover new price equilibrium before settling down.

Patterns

Prices move in patterns. Or more precisely, the underlying emotional and psychological forces tend to move in patterns and in a very predictable ways, hence the overt representations of such thought-set are reflected in price charts as patterns.

Over a period of decades, there are certain observable and definable price patterns which can be traded upon. For a new comer the ease of identifying patterns and seeing them coming true are exhilarating.

Patterns however have a very low reliability in short term, though they remain valid for longer term, with sufficient pinch of salt. The thing that makes Patterns unreliable is that it is so easy to identify and guess-estimate that lots of novice players use it, and hence most often than not, end up mis-reading it or being faked by it.

Unfortunately, most of the proponents, at least the non-serious kind, never delve past the lowest hanging fruit that is patterns.

Strategy: Trading on patterns are simplest of strategies but are self-defeating in short term or in heavily manipulated instruments.

Pros: Easy to understand and execute

Cons: Very predictable hence losing reliability