How The Markets Really Work

Welcome to the largest business in the world. Every day billions of dollars exchange hands in the world stock markets, financial futures, currency and crypto markets. Trading these markets is by far the biggest business on the planet. The average person has no idea what drives the financial markets. Even more surprising is that the average trader doesn’t know what drives the markets either. So, despite financial trading being the largest business in the world, it’s also the least understood business in the world.

Sudden moves are a mystery, arriving when they are least expected, and appearing to have little logic attached to them. Frequently the market does the exact opposite of a trader’s intuitive judgment. Even those people who make a living from trading, particularly the brokers and the pundits, who you would expect to have a detailed knowledge of the cause and effect in their chosen field, very often know little about how the markets work.

Essentially the financial markets show a lot of similarities with the other types of markets. If you look, for instance at a street market, it consists of four things: location, items for sale, buyers, and sellers. The location is known as a place to buy and sell items. The prices advertised by the seller are what the seller thinks they can get based on the competition in the location and the demand for the products by the passing buyers. In a buyers’ market, the prices fall and in a sellers’ market, where the demand is high, they rise.

The financial markets are not much different. Instead of antiques, clothes, and food, what’s been sold here are stocks, commodities, currencies and derivatives. Buyers purchase stocks and commodities through the trading exchanges such as the New York Stock Exchange (NYSE) or the Australian Stock Exchange (ASX). The sellers also sell through the exchanges with both sides using brokerage firms to transact the business.

Stock markets grew out of small meetings of people who wanted to buy and sell their stocks. These people realized that it would be much easier to make trades if they were all in the same place at the same time. Today, people worldwide use the stock markets to buy and sell stocks in thousands of different companies.

New issues of stock must be registered with the relevant exchange, such as the U.S. Securities and Exchange Commission or the London Stock Exchange. A prospectus giving details about the company’s operation and the stock to be issued is distributed to interested parties. Investment bankers buy large quantities of the stock from the company and re-sell the stock on the exchange.

Sitting between the markets and buyers and sellers are the brokerage firms. These firms act as an intermediary between the market and the buyer or seller. A potential buyer places an order with a broker for the stock he/she wishes to purchase. The transaction takes place when someone wants to sell and someone wants to purchase at the same price.

When you purchase a stock, you receive a stock certificate. The certificate may be issued on paper or issued electronically. It may be transferred from one owner to another, or it can be held by the broker on behalf of the investor.

What Affects the Markets?

There are several factors that affect the markets. They are individual, institutional, mutual funds and investors all affect market prices. If a large number of people want to buy a certain stock, the price of the stock initially is going to rally. Just as if there were many people bidding on an item at an auction. Both the condition of the individual business and the strength of the industry that it’s in, will affect the price of its stock. Profits earned, the volume of sales and even the time of the year will also affect how much an investor wants to own a stock.

Governments make all kinds of decisions that affect how much an individual stock may be worth and what sort of instruments people want to be investing in. The government’s interest rates, tax rates, trade policies and budget deficits all impact prices.

General trends that signal changes in the economy are watched closely by investors to predict what is going to happen next. Indicators include the gross national product, the inflation rate, the budget deficit and the unemployment rate. These indicators point to changes in the way ordinary people spend their money and how the economy is likely to perform.

Events from around the world and changes in currency values, trade barriers, wars, natural disasters, epidemics and changes in government all affect how people think about the value of different investments and about how they should invest in the future.

A bull market and a bear market are terms used to describe market trends. A bull market is a period when prices are generally rising. If investors feel that they will be in a bull market, they will feel confident in investing, adding to the market’s growth.

A bear market is a period when stock prices are generally falling. If investors think that the markets are generally falling, they will sell stock at lower prices. Each of these markets is fueled by investors’ perceptions of where the economy and markets are going. These trends can quickly change.

The first secret in learning to trade successfully is to forget about the intrinsic value of a stock or any other instrument. What you need to be concerned with is its perceived value, its value to the market and not the value that it represents as its interest in the company. This is a contradiction that undoubtedly mystifies the directors of strong companies with low stock value. From now on it’s the perceived value which is reflected in the price of the stock.

How, When and Why Markets Go Up and Down

So, who trades the markets?

The markets are traded by several trading entities. Most people will be aware of three entities. The first group is retail traders, people like you or me who trade the markets either as a full-time job, part-time for a second income or as a hobby. If we are trading full-time, we will place trades in the live markets. If we trade as a hobby, we might take position trades daily.

The second group is the pension funds which trade longer-term positions, holding stocks for weeks or months. The final group controls about 85% of the money in the markets and they are what we call “Smart Money”. They are made up of hedge funds, private trading syndicates, and investment banks. These entities have the power to move the markets. These professional players sell at the top of the market and buy at the bottom. In between, they must move the markets by making them rise and fall. To do this, they use the emotions of greed and fear to herd most traders into the wrong side of the market.

They have developed many ways of wrong-footing retail investors and traders and one of their biggest weapons is the unwitting media. Here are just a few examples. Let’s start with the British Petroleum oil spill disaster in 2010. On the 25th of June 2010, the stock price of BP fell to just under $27.00. The news was grim. The pundits and reporters were talking in terms of huge losses and a possible breakup of the company and everyone who had stock was looking to sell from the expectation that prices were plummeting. Sell they did, straight into the hands of the smart money, professionals who bought cheap. Within six months the price of the stock doubled. Buy cheap, sell back when the market rises, that’s how the game’s played.

On May 6th, 2010, something very strange happened in the financial markets. This day is now referred to as the flash crash because no credible explanation has ever been provided by the regulatory authorities as to exactly what caused the crash, or who was responsible. In fact, many investors began to suspect that all was not what it seemed to be. CNBC’s ‘Closing Bell” anchor Maria Bartiromo was reporting on the day the ‘Flash Crash’ happened. Below is the transcript of fellow reporter Matt Nesto explaining to Bartiromo some unusual anomalies in several stocks, even though the mainstream media claimed that it was caused by a lone trader from a major banking institution hitting the wrong button. ‘B’ for billion was entered instead of an ‘M’ for million while trading the CMS eMini S&P Futures. The conversation went as follows:

NESTO: “A person familiar with the Citi investigation said one focus of the trading probes were the futures contracts tied to the S&P 500 stock index known as the eMini S&P 500 futures, and in particular, that two-minute window in which 16 billion of the futures were sold… Again, those sources are telling us that Citigroup’s total eMini volume for the entire day was only 9 billion, suggesting that the origin of the trades was elsewhere.”

Nesto named eight stocks that were hit with the supposed computer error/bad trade that went all the way down to zero or one cent, including Exelon (NYSE:EXC), Accenture (NYSE:ACN), CenterPoint Energy (NYSE:CNP), Eagle Material (NYSE:EXP), Genpact Ltd (NYSE:G), ITC Holdings (NYSE:ITC), Brown & Brown (NYSE:BRO), Casey’s General (NASDAQ:CASY) and Boston Beer (NYSE:SAM)

NESTO: “Now according to someone else close to Citigroup’s own probe of the situation, the eMinis trade on the CME. Now, Maria, I want to add something else, just in terms of these erroneous trades that Duncan Niederauer; the NYSE CEO was talking about. I mean, we’ve talked a lot about Accenture, ACN. This is a Dublin-based company. It’s not in any of the indexes. If you look in the S&P 500, for example, I show at least two stocks that traded to zero or one cent – Exelon and CenterPoint.

If you look in the Russel 1000, I show Eagle Materials, Genpact, ITC and Brown & Brown, also trading to zero or a penny, and also Casey’s General Stores, as well as Boston Beer trading today, intraday, to zero or a penny. So they have at least eight names that they’re going to have to track down on top of the Accenture trade, where we have the stock price intraday showing us at least, we’ll assume, a bogus trade of zero.”

When Matt Nesto called these trades ‘bogus’, host and CNBC veteran Maria Bartiromo looked shocked and a little angry and replied:

BARTIROMO: “That is ridiculous, I mean this really sounds like market manipulation to me. This is outrageous.” According to Nesto, these are frequent occurrences, at least at the NASDAQ exchange, and if you make a trade and lose money, there’s no recourse.

NESTO: “It happens a lot. It really does. I mean, we could probably ask the NASDAQ, they may not want to say how often it happens, but it happens frequently. And they go back, and they correct. And the thing that stinks is if you, in good faith, put in a trade and made money and then lost it, you lose it. And there’s no recourse and there’s no way to appeal.”

What we witnessed on May 6th, 2010, was a giant shakeout of the market. Smart Money was expecting higher prices and wanted to catch the retail traders by marking the price down heavily, before moving the price up. They were bullish, the stocks were going to rise, and they wanted to buy at the best possible price. Wouldn’t you want to do the same? Buy at the lowest price, knowing you can sell it for much more than you bought it for. That’s the trading game, buy low sell high.

Be a predator, a clever predator that understands exactly how the prey thinks and acts. It’s like herding sheep, steering them, rounding them up and locking them in a pen.

In 2009, gas and petrol prices skyrocketed around the world and oil was supposed to be in scarce supply. Some of the world’s top oil analysts were predicting a price of $200 per barrel. You can appreciate for yourself, just how influenced someone can become when you see and hear information that all points in one direction. In this case, oil was to go to $200 per barrel, and many traders and investors and indeed even the airlines got caught up in the maelstrom of higher prices. A headline in the New York Times stated, “An Oracle of oil predicts $200 a barrel of crude” on May 21st, 2009. Exactly three weeks later the price of crude oil plummeted.

In April 2011, silver was very much in the news as the commodity to invest in. The price had steadily risen towards $50, and all the news was about the relentless rise of silver. This commodity had a very bullish medium-term outlook and once again, retail traders bought in abundance, anxious not to miss out. Later in 2011, silver crashed once the smart money had finished distributing at the highest price, so maximizing their profit.

CNN Money reported; “J.P. Morgan scores big in the latest quarter” is the headline 14th October 2009. The words strongest performance towered above Wall St expectations are used directly below the headline. All the news is now bullish; the stock is going up and up because it’s in an uptrend. To the retail trader and the investing community, this appeared to be a great opportunity to buy, because everything lined up and if you didn’t go to the market by now, you missed the move. So, you buy, buy, buy. What happened? The stock plummeted spectacularly, and the uninformed retail trader said bye-bye to their capital.

These are just very few examples; the reality is that all markets are moved to a greater or lesser extent the same way and it’s why a small and enlightened minority of traders are successful in the markets. So, we have seen how markets rise and fall, and why they fall. So how do you know when markets will change direction?

Traditionally, there have been two ways to try and predict price movement, technical analysis and fundamental analysis. Let’s begin with technical analysis. Wikipedia defines technical analysis as “a security analysis discipline for forecasting the future direction of prices through the study of past market data.” Another definition, this time from City Index is “Analysis of a financial market by charting its performance using historical patterns and focusing on trends.”

There are many technical analysis tools and methodologies out there, like Bollinger Bands, MACD, and Stochastics, which use mathematical formulas to identify trends. Others like Fibonacci and Elliot Wave use historical patterns. In summary, technical analysis tools look at historical price movement and based on the price action, you can determine to some level where the price will go. By looking at charts, you can identify trends and patterns which will help you find good trading opportunities.

Fundamental analysis is a way of looking at the market through economic, social and political forces that affect supply and demand. In other words, you look at what economy is doing well and whose economy is strong. The idea behind this type of analysis is that if the country’s economy is doing well, its currency will also be doing well. This is because the better the country’s economy the more trust other countries have in that currency.

Both these analysis models can provide valuable help for traders and investors. The question arises, well if they’re good, why do over 90% of people lose money in the markets? Well, the actual day-to-day movement of the market is shrouded in deep, dense fog, which is why the technical and fundamental analysis approach cannot be sufficiently successful on its own. That fog is deliberately generated by the market makers and the trading syndicates to force you, the retail trader, onto the wrong side of the trade.

Technical analysis tools try to predict price movement, by analyzing in various ways what the market is going to do, based on what it did historically. It’s a bit like trying to predict what the weather is going to do tomorrow based on what it did in a similar period historically.

That would be a more successful approach if the market behaved consistently, unfortunately, it appears to be unpredictable. The reason for this is that smart money, trading professionals constantly monitor both sides of the market and know exactly when to move the market as it wrong-foots the retail traders. The “Smart Money” do it in a very subtle and clever way, which is invisible, hidden in the fog. This means just as your technical analysis indicators tell you to enter the market, the market turns, and you are locked in at higher prices and you’ve lost.

So, technical analysis on its own cannot alert you to the real movements in the markets, because the market does not work in a vacuum. Going back to that real street market, if you are not an enlightened expert, knowing exactly what to look for, how likely are you to find a bargain when the people that you are buying it from are full-time experienced traders? The same is true in all financial markets.
Fundamental analysis relies on research, whether it’s researching an economy or its currency, commerce or individual company performance. That research requires reading articles, and reports and listening to the news. Taking too much notice of incoming news stories and reports in the media is one of the main reasons why traders and investors make very poor trading and investing decisions at the wrong time.

Here is an example, the chairman of the Federal Reserve appears on television, and makes what appears to be a bearish statement. The markets fall alarmingly in response to this news. The news reporter appears grim-faced on television, reporting why the market has fallen today – “The market has fallen dramatically today, on negative statements made by the chairman of the Federal Reserve.” To add to the impact and drama of the announcement, any other negative information is collected to support the story.

Why is the news release leading you astray and harming your trading? Because this is how the news should have been reported; “The market has fallen alarmingly today. Bearish statements made by the chairman of the Federal Reserve, caused the professionals to mark the market down, in a manoeuvre to discount the negative news. This influenced weak holders and uninformed traders, causing them to panic sell their holdings to professional traders, who have been waiting for this opportunity to buy at lower prices.”

It was highly likely professional traders, the “Smart Money”, was fully aware of the forthcoming press release well in advance of the announcement, and they were ready to absorb the huge amount of stock. They stand to profit handsomely in the days ahead as a result of the successful and expertly timed operation. Fundamental analysis can’t accurately point to price movement because the media is all too often manipulated and used by smart money to wrongfoot the retail trader.

Remember it’s perceived value and not actual value. There is another methodology which is the missing piece of the jigsaw, it’s called Volume Spread Analysis (VSA) and it lifts the fog, it identifies, when interpreted correctly whether the smart money is buying, selling, or not actively participating in the markets.