Markets don’t ‘gap around’ as what you might expect to find in a perfectly efficient market. When price moves from A to B, it seldom moves in a straight line either. To get from A to B, price moves in that direction, retraces a little, moves in that direction again (more than the retracement), retraces, and so on. So why do pull backs / retracements happen? What causes them?
There are numerous reasons why pull backs / retracements occur. I’d just list a couple below. For the sake of simplicity, let’s assume that we are talking about an uptrend.
- Natural supply / demand dynamics
- For a normal price move (not a momentum capitulation-type move) upwards, the further price stretches up, the less buyers join into the move. After some time, whoever wants to buy already has bought, and those who feel that it is too extended are either waiting for a retracement to buy, or are looking to short the move.
- Sellers will start testing the strength of the move at a point where they feel that the buying strength is low enough to be turned, and as the sellers join the fight, people who are long will see the upward momentum drop, and some will sell out, which adds to the downward momentum.
- Countertrend players seeing the start of the retracement will also start shorting, contributing to the supply.
- The long big players who are pushing the market up will also lighten up, so that they can recycle their capital to support the market after the retracement, in order to ensure that there will be a higher swing low.
- Due to the (i) lack of demand from buyers, (ii) supply from long scalpers, (iii) supply from new countertrend players, (iv) supply from the long big players who are pushing the price up, the retracement happens like clockwork.
- In the case of a momentum capitulation type move, there is a strong surge of demand, followed by more demand from amateur players chasing the market, and once the sellers see that the buying momentum has stalled, all of them strike to catch that bit of very high probability morsel.
- Manipulation by market movers
- I wrote above that one of the reasons for pullbacks is for market movers to recycle their capital so as to continue supporting the market move in a particular direction.
- One point I would add here is that this ‘recycling of capital’ sometimes generates whole trends, rather than just a small pullback. For example, say there is an aggressive upward push by a big player. The market moves a whole lot upwards over a period of time, then it finally hit consistent supply such that the big player could not push it up any further. At this point, the big player would likely start dumping a large amount of their long inventory. The market goes into a steep decline, almost covering the entire distance of the first upward trend, before the big player starts to scoop up all the inventory at a low price. This exercise boosted his firepower in terms of (1) having more capital to absorb supply, and (2) being able to absorb supply at much lower prices. Finally the big player quickly pushes the market back up, blasts through the original high point that he couldn’t get through earlier, and that’s it for the session, three nice big trends.
- Shaking out weak hands
- In order for a market to push higher, it needs to shake out the weak hands (those existing long players who sells into the retracements, usually at the bottom) by engineering retracements. After the retracements, those who held on to their original long positions will be joined by new long players who will be holding on for the next leg or more. This is a necessary ingredient to allow the big players to push the price above previous resistance and up into higher ground.
- Stops hunting
- The big players know that there will be traders trailing their stops up with the market. When there are stops, the market will hunt them down. You can read about the counter-trend non-farm payroll Friday phenomena here, where players who had already placed their bets and won have trailing stops to lock in their profits. Algorithms and big players hunt these stops which further adds to the supply that causes retracements / pull backs to occur.
- Action by market makers
- In markets where there are market makers, e.g. stock exchange specialists, if the demand suddenly increases forcing the the specialist to short sell, he would need to take the price down so that he can cover at a lower price.
- Vacuum effect
- I read about this explanation before but I don’t fully buy it. Basically the explanation goes that when demand overwhelms supply and price moves up quickly, it takes time for the volume just below the bid to fill up again. And while the ‘gap’ in volume exists, sellers take advantage and sells it down before volume thickens up again beneath the bid to stop the retracement.
- The reason why I don’t buy this is that it really depends on whoever is pushing up the market. If it is a well-managed operation, blocks of volume across the levels beneath the bid can remain thick all the way through a good push. Yes now and then you might see a lone ranger slashing through the offer levels without looking behind for reinforcements, but that is not the main reason why pull backs develop.
On a related note, there are two interesting phenomena when you look at the number of contracts in the bid and ask columns of the DOM
- As the bid-ask moves, you will find that the volumes trailing the bid-ask start to thicken up. Why is that?
- Part of the reason is due to “bargain hunting” by two groups of traders. The first group wants to initiate a position, yet does not want to take a price where the fighting currently is at. This is especially for contracts where there tends to be a decent amount of milling up and down, so grabbing the immediate bid-ask may seem to be “riskier”. They may also think that price has moved a certain distance and they don’t want to “chase”. So they queue a few ticks behind the bid-ask hoping to get a bargain entry as price fluctuates around. For example, if the bid-ask is at 13005/13010 and moves to 12990, the ask volumes will start to thicken up behind the 13010 ask, following its movement down.
- The second group are the ones who are trying to exit their positions. Similarly they want to exit their positions at a better price. This bunch is the dangerous bunch, especially if they are having open losses and are trying to realize their loss while seeing their losses get larger and larger as they trail behind the bid-ask.
- Another phenomena is that the number of contracts at a level typically decreases as the bid-ask gets nearer to it.
- For example, say there are 40 contracts waiting to buy at 12990, and the bid-ask is at 13005/13010. If your buy price was below 12990, you might initially think that hey there are 40 contracts sitting at 12990 to buffer you at that level. But no, what tends to happen is probably by the time the bid-ask nears 12990, the number of contracts drops down to say 15.
- One reason why that happens is the natural human tendency to extrapolate something when there is a recent momentum in that direction. Imagine that you are one of the buyers sitting at 12990. When you see price approaching your level, especially if it is at a fast momentum, a usual human impulse would be to feel that the price is going to blast right through 12990. So what do you do? You “get out of the way” by moving or removing your order hoping to get it at a better price. That’s what most retail traders do, and partly explains why volume shrinks quickly as the bid-ask gets near.