Price Formation: Supply, Demand and Liquidity

Orders as the source of price movement

A price rises when buyers are prepared to transact at a level above the price currently offered by sellers, and a sufficient volume of such buyers act on that willingness. A price falls when the reverse occurs. The mechanism depends on executed orders. A view on value that is held but not expressed through a transaction has no effect on the price; the same view submitted as an order alters the balance between supply and demand and moves the price accordingly.

This distinction explains why measures of stated sentiment, such as surveys of investor opinion or discussion on social media, are weak indicators of subsequent price movement. They record what participants report, not what they have done with their capital. Price itself is the only complete record of executed intent, and the analysis of price is accordingly the foundation of the technical methods introduced later in this course.

The function of liquidity

Liquidity is the capacity of a market to absorb transactions without a material change in price. A deep market contains a large volume of resting orders close to the current price, so that a sizeable transaction is filled with minimal displacement. EUR/USD during the London session is an example of a deep market: a large order is absorbed with little visible effect. The same order submitted in a less commonly traded currency pair outside its principal trading hours may move the price noticeably.

Many price movements that appear anomalous on a chart are explained by liquidity rather than by information. A large candle formed outside the principal sessions is more often the product of a thin order book than of significant news. Liquidity varies through the trading day as regional sessions open and close, and the trading hours page on the Onys Kapital website sets out the session times for each instrument.

• Deep liquidity: narrow spreads, orderly price movement and more reliable technical levels.
• Thin liquidity: wider spreads, price gaps and stop-loss orders executed at less favourable levels.
• Liquidity conditions change through the day as regional sessions overlap and close.

The role of expectation in price formation

Markets incorporate expectations in advance of events. A currency may decline following an interest rate increase by its central bank because the increase had been anticipated and was already reflected in the price, while the accompanying statement indicated a slower pace of further increases than the market had assumed. The price responds to the difference between the outcome and the prior expectation, not to the outcome in isolation.

The tradeable element of a scheduled release is therefore the deviation from consensus. A result in line with consensus may produce little movement, whereas a modest deviation from a strongly held expectation may produce a large one. The economic calendar on the Onys Kapital website lists scheduled releases together with the consensus forecast and the previous value, which allows the expectation to be identified before the release occurs.

Practical assessment of market conditions

The principal application of this material is that context is a more reliable guide than prediction. Before opening a position, a trader should be able to state which categories of participant are likely to be active at that time, how deep the market is under current conditions, and what outcome the market already expects from any scheduled event. These assessments do not indicate the direction of the next movement.

They do, however, indicate how much confidence an observed movement warrants. A breakout that occurs during a period of deep liquidity with broad participation carries more information than an equivalent movement produced by a small number of orders in a thin market. Incorporating this assessment into the evaluation of each trading opportunity is a habit that distinguishes systematic participants from those who react to the appearance of the chart alone.