Wall Street Survivor

So let me start your stock trading education with an explanation of how the stock market works, and if you are new to trading, then you may find the following hard to believe, but this is how the stock market game really work in practice, whichever markets you trade. So let’s start with the role of the market makers, and how they use their unique position in the market to manipulate prices and markets daily, to their own advantage. This is insider dealing on a grand scale, and yet market makers are regulated and operate day in day out, making huge sums of money every day, simply by virtue of seeing both sides of the market. So let’s take a look at the role of the market maker and from there I can then start to explain how we can use this knowledge to follow them ourselves, buying when they buy and selling when they sell. After all, if they can see both sides of the market at once, they are in a unique position to know when the market is about to rise and also when it is about to fall, and if we can follow them as well then we have the perfect trading signals for our own stock trading.

This is the basic principle that I use in all my online stock trading, but the underlying principle is an acceptance of the role of the market maker. If you believe what I am about to describe, then this will open your mind to the principle of volume spread analysis which combine this knowledge with the single most important indicator in the stock trading game, and that’s volume. Volume is the only activity that the market makers cannot hide – they can hide everything else, but the stock markets around the world report trading volumes second by second and hour by hour, which means that we also see the market makers activity each and every day. Follow the market makers and we are then trading with our own inside knowledge, providing us with a unique view of the future direction of the stock market. So how do the market makers play this game and how do we follow them as a result ?  The answer is volume spread analysis, which combines price analysis of the chart with the associated volume, to allow us to read the market and forecast future price direction with confidence.

Stock trading tutorial

So, if you have never traded in the stock markets before, let be start by explaining the role of the market maker, and how they use their privileged position to manipulate the markets every day.

Whenever you decide to buy or sell a stock or share, there will always be a willing buyer or a willing seller, and the reason for this is very simple – it is the role of the market maker to ‘make a market’ in every stock or share that is listed on the respective stock exchange, and as such have a duty and responsibility to ensure that whenever a buyer or seller enters the market, there is always someone able and willing to either buy if you are selling, or to sell if you are buying. As I am sure you know, all stock trading is executed through a central exchange such as the London Stock Exchange or the New York Stock Exchange, and as such trading takes place in a highly regulated environment. Now in order to ensure that there is continuous market liquidity, at the centre of the trading process sit the market markers who are authorised to ‘create the market’ for each stock or share. These are generally well know international banks such as JP Morgan, Goldman Sachs, and Deutsche Bank. As such they have to absorb all sell orders onto their books, and be able to supply when buy orders are increasing, and therefore they are continually having to manage the supply and demand of the stocks for which they are responsible, to make sure they do not have too much stock that they cannot sell when demand is low, or too little when demand is high.

The analogy I always use for a market maker in the real world is that of a wholesaler of goods, who has a warehouse where the level of stock is constantly changing to meet demand. When demand is high, the wholesaler has to purchase more stock quickly to satisfy this demand, and equally when demand is low, he has to ensure that stock levels are kept low, otherwise he will have to sell at a discount to reduce stock levels. This analogy has many parallels with the market makers in the stock markets, where sudden demand could leave the market maker short of stock, whilst a sudden panic in the market could leave the market maker with very high stock levels and no willing buyers. The market maker however is in a unique position, sitting at the centre of the market, and at any time in the trading session, is able to see both sides of the market, allowing them to see the balance of supply and demand second by second throughout the trading day. So how do they overcome this problem and keep their books in balance? – the answer is very simple – they use the news and rumour to manipulate the market each and every day. How do we as stock traders see what they are doing – again the answer is very simple – we use the one indicator that tells us exactly what is happening, and whether the market makers ( known as the professional money) are taking part in the move. If they are, then it is a genuine move, and if not, then it is a false move designed to trap you as a stock trader.

Suppose for example the market makers are short of stock, and some bad news appears on the Reuters news feed, then this provides an excellent opportunity for the market makers to move the market down suddenly, shaking investors out, who sell in fear that the market may fall further, allowing the market makers to replenish their warehouse as the market falls with increasing volume as a result, which clearly indicates the increase in selling. However, how do we know when the market makers have finished their buying ( their warehouse is now full again) and are ready to move the market higher once again – the answer is simple – volume and price. When the price spreads narrow on the price chart, but the volume is still high, then this signals to us as stock traders that the market makers are now buying into the market to prevent it falling further. Until then the market maker had been buying and selling in the normal way. This must be the case, otherwise the market would continue to fall. So our volume spread analysis tells us that the market makers are now buying preventing the price falling further, as a result of the narrow price spread and high volume, clearly indicating that the market is likely to turn shortly, and as such allowing us to buy with confidence knowing that the market makers will be taking the stock market higher in due course. This is a very simple example of how volume spread analysis gives us a clear view on the future direction of the markets, using our knowledge of how the market makers work, combined with an analysis of the associated price spread and volume. This is a key skill which you should practice in your virtual stock trading account, and in particular watch the volume of the markets in the morning, as you will see the market makers playing their tricks every single day. Early morning is an excellent example where you will see a stock move higher on low volume but a wide spread up candle, clearly indicating that the market makers are not joining the move, and simply taking the stock higher to suck in buyers in a trap up move, before taking the price lower, and leaving those buyers trapped at this level. Equally you will often see a stock moving higher, with substantial volume, but with a very narrow price spread. This clearly indicates that the market makers are selling, dumping stock into a market that is unwilling to buy so they hold the price there for as long as possible, before moving sharply lower in due course, giving us an excellent sell signal as we wait for the stock price to fall in due course.

This is how the stock markets really work – you can believe it or not, but if you test this out in the virtual stock trading game by using the volume indicator, you will see it at work in every time frame and every chart. So let’s look at some simple examples which I hope will reinforce  volume spread analysis as a unique trading system, and if you are prepared to study and learn how to analysis the price volume relationship then it will give you a unique trading edge in your stock trading game, and more importantly when you begin online stock trading for real.