I’ve spent pretty much the past 24 hours thinking about market structure exclusively. I didn’t even join in when my kids starting playing Guitar Hero on the Wii. Here’s the USDJPY chart, I find this one very interesting because it seems to be a battle between smart money and a central bank.

USDJPY M15 (click to enlarge)

The smart money seems to be supplying looking for a move further to the downside (I might be completely wrong and off-the-wall with this, but bear with me). The BoJ however, is sitting on the bid because it does not want the Yen to get any stronger as it’s harming exports out of Japan. Although the chart looks calm on the left side, a storm is brewing with a violent upside move probable. As the BoJ have deeper pockets than most, there is no way that even the institutions can go stop hunting. The BoJ sits on the bid and the other smart money is sitting on the offer and we end up in a tight range. When BoJ has loaded up on the bid, they start hitting the offers with buy market orders.

The buy-stops then get triggered in a violent cascade and the BoJ add to that by thowing in more buy market orders. When this cascade runs out of steam, the BoJ sits on the bid at 78.20 to prevent the market moving back down. The market pauses here and as it cannot move lower, it then cascades through longer-timeframe traders’ stop levels and propels the market even higher. When the market reaches 79.70 – 80.00 it gets interesting. As news has hit the market that the BoJ has been buying, some people jump on the shirt-tails and buy the market too. We get a spike up into 80.20 and here we have thick offers from the smart money. The market can only go so far. We now have a lot of newbies stuck long on the excitement of the BoJ buying. What MUST the market do now? Move lower, because there is a thick institutional offer and a ton of sell stops below 79.30 area.

What do you think of this reasoning? It’s all very well in hindsight, which is why I have placed a demand area in the far right of the chart. The market if it breaks 79.30 must now move down to the 77.20-76.90 area. It will be interesting to see what happens without the benefit of hindsight and I might be completely wrong in all my thinking and rambling.

Over the last few days I’ve been wondering to myself why does the market move the way it does? This is a question that probably passes through many traders’ minds when they are starting out and learning to trade. I’ve been thinking deeply about this and thinking how would I act in the market if I had, say $50 billion to play with. Not a lot, I know as the BoJ recently illustrated with their feeble attempts to weaken the Yen. That epsiode really shows how deep the FX market is. Anyway, I digress.

When looking at the charts I see areas of congestion where the market “rests” after a relatively big move. I’m proposing that these areas are where the “smart money” also known as the “big boys” are buying/selling with limit orders. In other words they are providing liquidity to the market for the “dumb money” to consume. After all the biggest providers of liquidity must have the most money. Let me illustrate with a chart (click to enlarge)

EURGBP market micro-structure (click to enlarge)

So working from left to right on the above chart, the smart money is distributing in the areas marked supply. When the buy market orders cannot chip through all the sell limit orders, the market MUST move down. It cannot move up. Why? In order to move up the buy market orders (also known as bulls) must consume all the limit orders. If there is a thick layer of institutional limit orders distributing at that level, then it will take a lot of buy market orders to break that level. The only people that can do this are very large investment banks or central banks (like the BoJ).

So the next question is, the market HAS to go down from the level of supply. But, where is it going to? To a level of demand. It’s basic, simple stuff but something I’ve not really thought about at length before. When you think about it, it’s really obvious and simple stuff. Now, the interesting bit is when a big player comes in to manipulate the market for their own gain. Look at the first area of demand in the chart. There is lots of smart money buying going on, most likely profiting from the distribution from the supply area. Smart money is covering shorts and both types of order were limit orders. When the bears (sell market orders) have done all their selling, the market MUST move up, and this is what we see.

The next area is the interesting bit. There has obviously been a lot of buy limit orders resting there soaking up sell market orders – smart money buying. Now, at this point the smart money has really loaded up by sitting on the bid for a day or so just absorbing all the sell market orders that come in. How can I, an investment bank, or a large trader dump my stock? I move the market against my own position! Makes sense, right? It’s called stop hunting. The first white box I have shaded on the chart is where the guys that have loaded up with their limit orders, remove the bids. There is now no support in the market and it doesn’t take a lot of selling for the market to head lower against their position. This is fine, because all those people that starting selling the breakout of the consolidation area now have stops above. Smart money then sits on the bid a bit lower down to stop the market breaking down big time. The sell markets dry up, and what happens next? Yes, the market MUST move higher and gets fueled by all the buy stops above consolidation. At this point, if I was an institution I would throw fuel on the fire by adding to my position with buy market orders so that I get the market into the buy-stop zone.

I now have a HUGE long position in the market which is made up of filled buy limit orders by sitting on the bid during consolidation, and a boatload of filled buy market orders which is designed to find the stops of the break-out traders. With no smart money on the offer the market has no choice but to move swiftly up on the power of triggered buy stops and low sell-side liquidity. Smart money then distributes with a thick level of sell-limit orders to take profits (again) from the buy-stop cascade and suck in new buy-market losers. The whole cycle plays out again.

What I’m wondering is how do these people know where to bid and offer? Why bid at 0.8705 and offer at 0.8750? Why those prices? This post is just me thinking out loud on how the market is structured. I really want to understand this deeply and at a level where it is second nature and I would really appreciate any comments from traders that know this stuff and use it to their advantage. Feel free to contact me privately on the contact page.