The encryption market is like a puzzle! Decrypting Liquidity, spread logic, and understanding the secrets behind ups and downs

Trading: If we act in places where most people are willing to trade based on common sense... then this may mean that we do not have more valuable information than others.

One of the metaphors of market behavior: puzzle

I like to use puzzles to describe market behavior. You can imagine that the market as a whole is like a person trying to complete a puzzle, and Trading Volume is the pieces of the puzzle. The market will strive to put all the pieces together. By analyzing the distribution of Trading Volume, we can more clearly see where there is a lack of 'pieces'. When the market finds that there are more pieces in certain areas (i.e. where Trading Volume and time accumulate more), it will try to allocate these pieces to areas where there are fewer pieces (i.e. where Trading Volume and time accumulate less).

How to choose the direction of the market

Sometimes the market lacks "fragments" on both sides, so how do we determine which side it will fill first?

This reminds me of a theory about human behavior in the book 'Atomic Habits'. In such a situation, we need to pay attention to two key points:

Attraction: People usually hope that actions can bring returns, and the market is the same because it reflects the behavioral patterns of humans. As we discussed before, we tend to avoid overly crowded trading scenes, and more attractive strategies are usually contrary to the majority of misplaced participants, especially when we have clear structural basis.

drop resistance: According to the 'law of least effort', the greater the amount of effort required, the lower the likelihood of it happening. If the resistance is too high, the difficulty of reaching our goals will also increase.

Metaphor 2 of market behavior: the trolley problem

Imagine the market as a train, and this train is like a 'killer' that craves for 'hunting'. When we take action in the fair value zone, both sides of the market are crowded with participants, so it is difficult to predict which side it will choose to 'hunt' more people. However, once the market chooses one side, the other side becomes the only choice, making our decision-making process simpler.

Image source: ShenZhen TechFlow

What is Liquidity?

Liquidity refers to whether there are enough counterparties in the market for trading. When we trade, we either consume Liquidity or provide Liquidity. If the price is stable within a certain range (i.e., equilibrium zone) or unable to fluctuate smoothly, it is because the buyer fails to consume enough Liquidity; conversely, if the price can fluctuate smoothly, it indicates that the buyer has successfully consumed enough Liquidity.

Limit Order and Market Order

Limit orders add liquidity, while market orders are tools that complete transactions and consume this liquidity. Passive liquidity (limit orders) usually has more influence because limit orders often determine market structure, while aggressive market orders are absorbed at key points.

Why are limit orders more powerful? Because when you execute a market order, you need to cross the bid-ask spread, which means you will immediately be in an unrealized loss position after placing the order.

What is the spread?

The spread is the difference between the bid price (advertised price) and the ask price (advertised offer) of an asset. Market makers provide liquidity through spreads, which means that the price of buying an asset immediately is usually slightly higher than the market price, while the price of selling immediately is slightly lower than the market price.

Image source: ShenZhen TechFlow

Assuming the current price of an asset is 10.00, and the asterisk represents each contract. If we want to buy immediately, there is no quote of 10.00 in the market, because market makers cannot profit from it. Therefore, they will set the advertising liquidity slightly higher, for example, placing four contracts at 10.01 to capture this small difference.

If we decide to purchase three contracts, we will be executed at the price of 10.01. But what if we want to buy more, like 15 contracts? We will need to cross the spread until we find enough orders to complete the transaction. Therefore, the price will eventually be pushed to 10.03, because only at this price level, there are enough contracts to meet our needs.

Image source: ShenZhen TechFlow

Through this example, we can understand why limit orders usually have more impact. The influence of small-scale traders on the price can be negligible because they will not encounter significant Slippage. But if someone wants to buy 500 contracts and there is not enough Liquidity nearby, he will have to cross a huge spread, causing significant price Fluctuation.

If traders choose to place orders in areas with sufficient Liquidity, they can avoid significant Slippage. So, where is Liquidity usually concentrated? The answer is above swing highs and below swing lows. This is because most traders based on Technical Analysis exhibit similar behavior when stop loss, and these positions are often the concentration area of stop loss, and the price is also prone to reverse at these positions.

So, their stop loss is your entry point? Indeed.

Summary

Impatient buyers or sellers drive prices through market orders (initiators), consuming Liquidity.

More patient buyers or sellers prevent price Fluctuation through limit orders (passive party).

We can use a metaphor to describe: a market order is like a hammer, while a limit order is the floor or ceiling of a building. To break through the floor or ceiling, you need enough hammer force to break it.

Image source: ShenZhen TechFlow

What happens when the floor is broken? The price will quickly move to the next floor.

Image source: ShenZhen TechFlow

Once the price reaches the next floor, moving upwards will become easier, as the ceiling has already been broken, creating a 'gap', allowing the price to fluctuate more easily in areas with scarce Liquidity.

Image source: ShenZhen TechFlow

Liquidity Cascade is a very effective way to make money because we are trading with a price-insensitive group of traders (such as those who are forced to Close Position). But we need to be clear about what we are trading.

If you are trading Liquidity premiums, this effect is usually very short-lived, lasting no more than 10-15 seconds. In a cascading environment, this situation will change. In this case, you need to determine whether Liquidity has fully recovered from the initial Fluctuation.

Although the chain effect of momentum change is not as reliable as the Liquidity premium, its persistence is stronger (most people think they are trading the Liquidity premium when they are actually trading this momentum effect).

The first method (Liquidity premium) is more suitable for PNL attribution (i.e. analyzing the reasons for making money), and it is also a more ideal way of operation. The second method (momentum effect) can capture the core part of large Fluctuation, but it comes with greater Fluctuation and looser risk control.

Overall, Liquidity cascades can lead to imbalances in supply and demand as a large number of price-insensitive traders enter the market, overwhelming the order book with so many active traders. However, once the market stabilizes, prices will be more likely to return to areas that did not generate enough Trading Volume due to rapid Fluctuation.

After all, the market is a two-way auction mechanism that usually tests areas with low trading volume, and there are two reasons for this:

This path has a smaller resistance;

The market pursues efficiency, and it will test these areas to see if anyone is willing to trade at these price levels.

As a result, the market will experience a 'mechanical Rebound' because the order book needs time to rebalance. At this time, only a small Trading Volume is needed to drive price Fluctuation. Once the market stabilizes, price trends will rely more on momentum, accompanied by higher Fluctuation, but also able to capture more profits.

Please remember that high Fluctuation often follows high Fluctuation, and low Fluctuation often follows low Fluctuation. This is known as Fluctuation clustering phenomenon. Therefore, seize the opportunity and adjust your Risk Management strategy according to the changes in market conditions each time.

[Disclaimer] There are risks in the market, and investment needs to be cautious. This article does not constitute investment advice, and users should consider whether any opinions, views, or conclusions in this article are suitable for their specific situation. Investing based on this is at your own risk.

This article is authorized for reproduction from: "Shenzhen TechFlow"

Original author: TradeStream | Improve Your Trading

The encryption market is like a puzzle! Decrypt Liquidity, price difference logic, and understand the secrets behind the rise and fall. This article was first published in 'encryption city'