Liquidity and Auctions on Heatmaps
This post is part of a short series I am writing to explain in basic terms how a futures market auction is often graphically depicted by liquidity movement on a heatmap, such as the one available in Bookmap. Please note that this is an opinion/educational piece only and does not represent any form of financial advice.
The basic premise is as follows:
- The market is there to facilitate transactions between buyers and sellers
- The market is conducted as an auction where prices will continue in one direction until an opposing force pauses, halts or reverses price
In traditional auction theory people use the terms supply and demand instead of the term “force” but I’ll stick with the Star Wars analogy for my article as I find it easier to understand and applies more directly to heatmaps. In trading, we always want the force to be with us.
On a heatmap, the force of buyers and sellers in the marketplace is represented by liquidity appearing on the heatmap. If that liquidity (represented by more “intense” colors or shading depending on which heatmap you are using) appears above price then that force will be pushing down and if it appears below price that force will be pushing price up.
Depending upon the market, the distance from price to the liquidity also affects how much force that liquidity has in that marketplace. In thinner instruments such as Nasdaq and Crude Oil, liquidity placed far away will have more force than liquidity placed far away in thicker markets such as S&P futures. The logic for this is simple: it is harder to cut through treacle than it is to cut through air.
When liquidity (here meaning a big change in the number of orders at a price) first comes into the marketplace, it will most likely, as described above, repel price away from that liquidity as shown in this heatmap below.
However, if that liquidity (or a large proportion of it) stays or “rests” in the market after that initial repulsion then its force becomes reversed and it becomes a force of attraction.
Although this may seem contradictory or counter-intuitive, it aligns with one of the basic premises of markets described at the beginning of this article, namely that the market is there to facilitate transactions. In other words, if the liquidity that previously repelled price is now the biggest nearby liquidity and there is no more liquidity being added from that direction then the market has reason to travel back towards that liquidity as there is a good chance of transactions taking place there.
Turning to how to use this in intraday or even multiday trading, there are two clear lessons that the market is teaching us:
- Be aware of the changes in force that are coming into the marketplace as they are likely to have an immediate impact on price direction
- Take note of significant liquidity that “rests” in the marketplace as its initial impact on price and its longevity may well cause price to revisit it (whether through it or very close to it).
I’ll try to keep this series going.