Chapter 2
It’s free money! When you know what you’re doing
One of the instructors during my training for a pro trader course said something interesting that left an impression on me to this day. He was a Futures trader at the Chicago Mercantile Exchange for over 20 years. I remember discussing with him during lunch and we somehow landed on the topic of the 2008 crash of the housing market. We talked about the movie the big short and it led to him saying something to the effect of; “during the crash, there was a transfer of wealth from the people who didn’t know what they were doing to people who knew what was happening”. This stuck to me, painfully, because my family had been affected by a recession.
Since then and through my trading journey, I’ve heard similar sayings that circumvent the same principle of having a fundamental understanding of what drives price in the financial markets.
This knowledge enables you to have proper market timing, therefore giving you an edge in the markets to generate consistent profits, avoid losses, and know when to stay out of the markets. Without an edge in the markets, you’re just another participant who is on the wrong side of the transfer of wealth. When you know what you’re doing, however, it becomes free money essentially. Later down the line, I’m going to layout some critical guidelines for you to follow to gain an understanding of the principles of price action.
Before that allow me to illustrate this principle understanding;
I want you to have a mental exercise with me, do you remember ever taking a position on any particular asset class? You do? Great! Now I want you to think carefully about how you came to that decision. Got it? Good. If I was to guess, I would say it was an external piece of information that gave you an idea of what position to take. Either from the news, newspaper, friend, or family, research, social media, etc.
Next, Have you ever wondered why anytime you are about to buy into a “hot new” trend it’s almost too late? You either start to notice or hear about it gradually, then everywhere to the point it loses some value or appeal to you. Or the hype has driven price is a little too high as a result of conveyed value? IF your answer to all these questions were yes or maybe, congratulations you are not living under a rock somewhere.
Since you are not living under a rock somewhere, you have probably heard about Bitcoin.
Bitcoin got to the height of its popularity in December 2017, therefore this makes it a good place to start a case study as it is fairly recent. The first time I heard or read about bitcoin was in a random article I do not even remember in 2014. What I do remember was the thought that followed; “this sounds like a thing of the future I should buy some”. I was a broke college grad at the time, I could not fathom paying $500 for some intangible bullsh*t online- I also thought. Fast forward to 2017, Bitcoin started trading at $1300, then $3500, and by the end of the year, bitcoin got to $19,000. Obviously, cryptocurrency and blockchain is a thing of the future and has a lot of merits.
But now I want you to observe the power of conveyed value in society.
If at some point it was trading at $500, $1000- then gradually it started trading above $5000, $10,000- What do you think the reason for this was? If your answer was demand then congratulations again! You know economics. The demand for Bitcoin, this intangible thing, skyrocketed. People were taking out second and third mortgages to buy Bitcoin! So with all that said, if everyone was buying Bitcoin, who was selling it?
Now I bring your attention back to the concept of “Effectual Demand” we covered earlier.
By the time you wanted to buy bitcoin, it might have been too expensive to justify the purchase, or you didn’t have enough of an understanding of blockchain. Even worse was if the price dropped all the way back to $7000 after you bought in at say $18,000. Yea’ buddy I know it hurts to remember. As an individual, when you bought bitcoin or wanted to buy bitcoin after all the hype, you were part of a category of demand called absolute or retail demand. Having established this fact that you were the retail consumer, let’s circle back to my previous question. Who was selling Bitcoin? Well, it’s easy now, the sellers were the ones taking profit while fulfilling your buy orders. The sellers were just buyers who bought bitcoin way before the hype at a wholesale price and sold it at retail price. This is what effectual demand is; Wholesale demand.
Adam Smith believed that the price of a product or service was driven by the balance between the supply and demand of that price or product. In other words, the willingness of a consumer to pay for a certain product determined the market value. With that said he also believed that effectual demand is what really determined the price of an asset and keeps the economy moving.
Effectual Demand by definition is a type of demand where a buyer is willing to purchase a product or service at a price that allows him to bring the product into the market. In other words, a wholesaler. The difference here is that the buyer is willing to purchase at a price that allows him to sell it at a higher price to cover wages, profit, rent, and compensation for buying in high quantities. The reason this is such a huge driving force behind our economy is that it is a feedback loop that creates incentives. Therefore when everyone was buying Bitcoin, the sellers were just the wholesale buyers who were fulfilling orders at a retail demand level, closing out portions of the overall volume of their initial positions taken.
For the last mental exercise, do you remember what happened to the price of bitcoin after it got to $20,000 back in 2017? I’ll spare you some brainpower to keep reading; IT REVERSED, VIOLENTLY! All the way back to $3500. Coincidence much? I think not. It capped at that price for multiple reasons,
- Effectual demand (wholesalers) offloading their positions in bitcoin for profit at the absolute(retail) value.
- - Excessive supply of bitcoin at retail demand levels.
- - An imbalance between Supply and Demand
When Bitcoin started to gain traction on the news and with institutions there were several attempts by regulatory bodies to challenge its place in our financial system. Eventually, laws were passed in favor of, there was a strong rally in price from the $3000 price point that ultimately led to a push to the $20,000 region.
So the next time you look at your charts ask yourself these series of questions; who is in control of the price, where are the buyers, where are the sellers, where is the demand(effectual), where is the supply(retail)?
When you look at the markets this way, you develop a keen sense of order flow and trade-balance in the markets. These are some of the critical guidelines for understanding the fundamental driving force behind price action on the charts. When you apply it properly with your trading style (so long as you know what you’re doing), it’s basically free money.
When Dr. Michael Burry noticed that there was an overage in the supply of lending, in form of subprime mortgages and flawed lending practices, he realized that this would ultimately lead to a loss of value when original rates replaced the subprime ones. He understood that and shorted the housing markets by betting against these subprime deals. He bet against big financial institutions by getting them to sell him credit default swaps which, in turn, paid him well. Although this is an oversimplification of what happened back then the underlying principle remained the same. There was an increase in supply of loans and a decrease in amounts of repayments because people preferred to spend on consumer goods and services(retail value) instead of paying back loans on an asset which they had effectual demand to sell at a markup. Ultimately this created an imbalance in the markets (a bubble) between supply and demand.
In the upcoming chapters, we shall dive a little deeper into the application of these concepts using examples.
Author
Edward Emono
Thanks for reading, if you want to get a copy of this book, “FundamentalTechnicals- A Guide to Improving your odds in the Financial Markets” be sure to visit our website and send us an email with the subject title; “book”
