Nature abhors a vacuum
If you want to understand why the market pulls back in an uptrend keep “Nature abhors a vacuum” in mind.
- An uptrend starts
- Price is at 2722
- There is ZERO buy side liquidity above 2722
- There IS buy side liquidity below 2722
- There IS sell side liquidity above 2722
- Market buy orders ‘”eat” the sell side liquidity and break through the ceiling
- Price moves up and up and up
- We are now at 2728
- There was no buy side liquidity above 2722 before
- There will be SOME buy side liquidity between 2722 and 2728 but it will be NEW liquidity that got placed there as price moved up
- Some of this new buy side liquidity will be Market Makers who were SELLING as the market moved up
- Traders will have submitted new buy side liquidity on the way up
- Traders will still be THINKING about submitting buy side liquidity
The area between 2722 and 2728 now has (to an extent) a “liquidity vacuum” on the buy side. The liquidity hasn’t had chance to build up in that area as it has on the sell side. We are at 2722 – we have moved up into an area where sell side liquidity has been sitting for a while. We moved up into an area where no buy side liquidity existed before but where sell side liquidity exists. The ceiling is strong and the floor is very weak. Any uptrend will have a mix of market buyers and market sellers eating liquidity on both sides.
If you only have market orders on one side, look out!
- We have market buyers and sellers, we have a strong ceiling and we have a weak floor.
- The market starts to move down as the weak floor is consumed on relatively little market selling
- Some new sellers may be thinking “reversal” and jump on short
- As we move down we move “further back” in time OR to prices that have been traded a while back and where there has been more time to consider a buy side limit order
- We move down and the floor gets a little thicker
- At the same time, we move down into an area with ZERO sell side liquidity, the vacuum is now being created above us.
Eventually, we get to a point where we have a thicker floor below us and a relatively thin ceiling above. Price starts to move up and a whole bunch of traders think “Continuation”. Anyone that sold the pullback starts to feel a little queasy and pukes out (by buying). We may see a little acceleration to the upside as the market becomes quite one-sided. Then the process starts over again.
See this video to understand the principle:
Music from Jukedeck - create your own at http://jukedeck.com
- The market is like a hi-rise building.
- It has floors (buy limit orders) and ceilings (sell limit orders).
- It takes market orders to eat these floors & ceilings.
- As you move up and go through a ceiling, it takes time to rebuild the floor behind you.
- This lack of a floor, or “liquidity vacuum” is the cause of pullbacks in trends.
- This represents opportunity for you. Once you know that the market is “vacuuming back”, you suddenly aren’t scared of fading that pullback.
- You also need to understand Tape Reading to tell you where this pullback will end.