High volatility often follows high volatility, while low volatility tends to be followed by low volatility.

Trading: If we act based on where most people are willing to trade, this may imply we don’t have more valuable information than others.

Metaphor for Market Behavior: The Puzzle

I like to describe market behaviour as a puzzle. Imagine the market as someone trying to complete a puzzle, with volume acting as the puzzle pieces. The market works to fit all the pieces together. By analyzing the volume distribution, we can more clearly identify where pieces are missing. When the market identifies areas with more pieces (i.e., regions with more accumulated volume and time), it will attempt to place those pieces into areas with fewer pieces (i.e., regions with less volume and time).

How the Market Chooses Its Direction

Sometimes, both sides of the market are missing pieces. How can we determine which side it will fill first?

This brings to mind a theory on human behaviour from the book Atomic Habits. In these situations, we should focus on two key points:

Attractiveness: People generally want their actions to yield rewards, and the market behaves similarly, as it reflects human patterns of behavior. As discussed earlier, we tend to avoid crowded trading situations. More attractive strategies are typically those that go against the majority of displaced participants, especially when we have clear structural reasons for doing so.

Reducing Resistance: According to the “Law of Least Effort,” the more energy something requires, the less likely it is to happen. If the resistance is too high, it will be harder to reach our goal.

Metaphor for Market Behavior: The Trolley Problem

Imagine the market as a train, eager to “hunt” like a “predator.” When we act in the fair value zone, both sides of the market are crowded with participants, making it difficult to predict which side the market will choose to “hunt” more people. However, once the market picks one side, the other side becomes the only remaining option, simplifying our decision-making process.

What is Liquidity?

Liquidity refers to the availability of counterparties in the market for executing trades. When we trade, we are either consuming liquidity or providing liquidity. If the price remains stable within a certain range (i.e., a balance zone) or fails to move smoothly, it means that buyers have not consumed enough liquidity. Conversely, if the price moves smoothly, it indicates that buyers have successfully consumed sufficient liquidity.

Limit Orders vs. Market Orders

Limit orders “add liquidity,” while market orders are tools to execute trades and consume liquidity. Passive liquidity (limit orders) tends to have more influence because limit orders often determine the market structure, while aggressive market orders get absorbed at key points.

Why are Limit Orders More Influential?

When you execute a market order, you must cross the bid-ask spread, which means you immediately enter a position with an unrealized loss after placing the order.

What is the Spread?

The spread is the difference between the buying price (ask) and the selling price (bid) of an asset. Market makers provide liquidity through the spread, meaning the price to buy an asset immediately is usually slightly higher than the market price, while the price to sell it immediately is slightly lower.

Let’s assume an asset’s current price is 10.00, with an asterisk (*) representing each contract. If we want to buy immediately, there is no quote at 10.00, because if there were, the market maker would not be able to profit. Therefore, they will set their liquidity a little higher, such as placing four contracts at 10.01, to capture this tiny spread.

If we decide to buy three contracts, we will transact at the price of 10.01. But what if we want to buy more, say, 15 contracts? We will need to cross the spread until we find enough orders to complete the transaction. As a result, the price will eventually be pushed to 10.03, as only at this level will there be enough contracts to satisfy our demand.

This example helps illustrate why limit orders are usually more influential. Small-scale traders have little impact on price, as they don’t experience significant slippage. However, if someone wants to purchase 500 contracts, and there isn’t enough liquidity nearby, they will have to cross a large spread, causing significant price movement.

If traders place their orders in areas with sufficient liquidity, they can avoid major slippage. So, where is liquidity typically concentrated? The answer is above swing highs and below swing lows. This is because most technical analysis-based traders exhibit similar behavior when triggering stop-loss orders. These levels often become areas of stop-loss clustering, where prices are more likely to reverse.

So, are their stop-losses your entry points? Indeed, they are.

Summary

• Impatient buyers or sellers use market orders (aggressive side) to push the price and consume liquidity.
• More patient buyers or sellers use limit orders (passive side) to prevent price fluctuations.

We can use a metaphor to describe this: market orders are like hammers, while limit orders are like the floor or ceiling of a building. To break through the floor or ceiling, there needs to be enough hammer force to break it.

What happens when the floor is broken?

The price will quickly move to the next floor.

Once the price reaches the next floor, moving upward becomes easier because the ceiling has been broken, creating a “gap,” allowing the price to move more freely in areas with scarce liquidity.

Liquidity cascading is a very effective way to make money because you’re trading with price-insensitive participants who are forced to transact (such as traders being liquidated). However, it’s crucial to be clear about what you’re actually trading.

When you trade liquidity premiums, the effect is usually very short-lived, lasting at most 10-15 seconds. In a cascading environment, this situation changes. Here, you need to assess whether liquidity has fully recovered from the initial volatility. The chain reaction of momentum shifts is not as reliable as liquidity premiums, but it has stronger persistence (many traders believe they are trading liquidity premiums, but they are trading this momentum effect).

The first method (liquidity premium) is more suitable for P&L attribution (i.e., analyzing why you made money) and is generally the more ideal approach. The second method (momentum effect) captures the core part of large price swings but comes with greater volatility and looser risk control.

In general, liquidity cascading leads to an imbalance in supply and demand because a large number of price-insensitive traders flood in, and the order book cannot handle such a volume of active traders. However, once the market stabilizes, the price is more likely to return to areas that lack sufficient volume due to rapid fluctuations.

After all, the market operates as a two-way auction mechanism, and it often tests low-volume areas for two reasons:

• These paths have less resistance;
• The market seeks efficiency, testing these areas to see if anyone is willing to trade at these price levels.

As a result, the market tends to experience a “mechanical rebound” because the order book needs time to rebalance. At this point, only a small amount of volume is required to move prices. Once the market stabilizes, price movements will be more dependent on momentum, accompanied by higher volatility, but with greater profit potential.

Remember, high volatility often follows high volatility, and low volatility follows low volatility—this is known as the volatility clustering phenomenon. Therefore, seize the opportunities and adjust your risk management strategies based on each market condition change.

Feel free to join the official TechFlow community:

Telegram subscription group: TechFlowDaily

Official Twitter account: TechFlowPost

English Twitter account: TechFlow_Intern

Disclaimer:

1. This article is reproduced from [TechFlow)]. The copyright belongs to the original author [TradeStream]. If you have any objection to the reprint, please contact Gate Learn team, the team will handle it as soon as possible according to relevant procedures.
2. Disclaimer: The views and opinions expressed in this article represent only the author’s personal views and do not constitute any investment advice.
3. Other language versions of the article are translated by the Gate Learn team. Unless otherwise stated, the translated article may not be copied, distributed or plagiarized.