Order flow trading is a type of market analysis which focuses on how other traders in the market make decisions.
The idea is if you can understand when and where traders are likely to place trades then you can come with a good determine what direction the market is about to move in, and the effect their orders have upon the price in the market, order flow trading itself is not a new method of trading, its been around since the dawn of financial markets, it’s just never been properly understood when compared to other trading strategies.
Order flow trading is less of a strategy and more of a mindset, it’s a way of looking at the market, not necessarily a way of trading it.
It’s important to distinguish between what order flow trading is when compared with price action trading.
Order flow trading falls into the category of price action trading as it does not require any indicators placed on the chart to make a trading decision.
Where it differs however, is the way you think about the things you see on your charts. In price action trading you may see a pin bar at support and decide to trade it, that’s where the analysis ends. In order flow trading your thinking about why the pin bar has appeared, What decision has taken place in the market took that has created the pin bar ? Was it professional traders taking profits ? maybe it was the stop losses of retail traders being hit ? There are many different things it can be depending on where the market is and whats currently going on, this is the higher level of thinking that order flow trading achieves.
Understanding the market in terms of price action is like level 1 – This is identifying what the different candlesticks you see on the charts mean.
Understanding the market in terms of order flow is level 2 – Knowing what’s caused the candlesticks on your charts to appear in the first place.
Where Does Order flow Trading Come From ?
The name order flow comes from how the orders used by traders come into the market.
In all other financial markets order flow trading would be conducted using a tool called the order book.
The order book gives the trader using it access to all the buy and sell orders coming into the markets from the various different trading exchanges all over the world. In addition to this, it also shows the size of these orders and the prices at which there being placed. For the people who have access to it, the order book provides a sizable advantage over other types of market analysis. Unfortunately for us, the order book is unavailable for us to use in the forex markets due to how there isn’t one central location where forex trading takes place, the closest thing we have to an order book is Oanda’s open position ratio which I actually use to trade stop hunts. This is no substitute for a true order book tool, it has many disadvantages and does not show the true amount of orders coming into the market.
Because of this we need to use own understanding of how people trade, in order to gauge when and where people are likely to place trades.
This may seem like an impossible task, I mean, there are hundreds of trading strategies used by traders worldwide. Luckily, we don’t need to learn all of these trading strategies in order to understand order flow trading properly, we just need to learn the one thing all traders using these strategies use in their decisions making process when placing trades.
The one thing which is consistent in every traders trading strategy is the trend.
All traders need the trend in order to make money, which means one of the primary things they will look at before making a trade is what direction is the market currently trending in, unfortunately the definition of trend that all traders have learned is wrong, and has been purposely implanted in their head to make them lose money. Think about this: Its said 90% of traders consistently lose money in the markets, this means their all doing something wrong ! What I don’t get is how can 90% of traders consistently lose money when their all using different trading strategies ? If you think about it there’s only two types of trading strategies you can trade, a trend trading strategy or a reversal strategy, both these types of strategy use the trend as the primary method of determining when to place a trade.
A trend trader needs a to see a trend in order to place a trade, a reversal trader needs to see a trend in order to anticipate when a reversal will take place, both types of trader will determine the trend in the same way either by using swing highs and lows or by using indicators, the problem with these methods is they are late in determining when a trend has begun.
By the time the trader has identified that a trend is taking place, the trend itself is nearly over meaning their going to be late getting into their trades.
If you want to learn more about how the concept of trend is used to make traders lose money check my new book out in the cool stuff section.
Market Orders And Pending Orders
The first thing you need to understand about order flow trading is how the different orders used by traders impact the market.
When you place a trade you can use either a market order or a pending order, these two orders have very different effects on the price in the market.
Market orders are employed by traders who want to trade right now, they have seen something happening in the market which they define as a trading opportunity and would like to take advantage of it immediately. Some examples of trading strategies which primarily use market orders as a means of entering their trades would be moving average systems.
Traders using moving averages will enter their trades when the averages cross, they have to do this using market orders, a limit order cannot be used as knowing when the averages will cross cannot be predicted.
Pending Orders ( Limit Orders )
Pending orders are used by traders who wish to have their trade placed in the future.
If you thought EUR/USD was going to fall when it reached 1.0700 you would use a pending order to have a trade placed at that price ready for when the market reached that level.
Both market orders and pending orders have different effects on the level of liquidity in the market.
Liquidity is a term used to describe how easy is it to buy or sell something in the market.
For us retail traders placing and closing trades is something we never need to think about, we do not trade in big enough amounts of money to ever have an effect on price changes within the market. On the other hand, large traders working in banks and hedge funds do trade at a size big enough to effect the market, this means it’s very important to them where and when they enter their trades.
Bank traders want to get their trades placed with as little impact as possible on the market price, its essential they do this because if they don’t they will suffer what’s know as slippage.
Slippage is where only part of their trade gets placed at the price they want, and the other part gets filled at a worse price. (more on this later )
Whenever the market moves up or moves down its due a lack of liquidity in the market, if the market makes a sudden move up its very difficult for bank traders to place buy trades as there is a lack of sellers in the market.
The candlesticks with arrows pointing at them are the types of movements which signify a lack of liquidity in the market, big one-sided movements make buying or selling extremely difficult for the professional trader. When you see big single candle down-moves ( often called large range candles ) it means professional traders are not able to place sell trades, when you see big up moves it means their not able to place buy trades.
Consolidations are the only type of market condition that offer bank traders the ability to buy or sell easily without having a big effect on the market price. Consolidations represent confusion in the market, with traders placing buy and sell trades trying to figure out which way the market is going to break, all this activity means bank traders can easily get their trades placed with very little impact on the market price.
Another thing which has an effect on liquidity in the market is time.
When markets are active the ability to buy or sell currency is easy as lots of traders are placing trades, not only that but lots of bank traders are in the market placing trades, which means bank traders are able to transact with one another. When the trading for each respective currencies dies down the level of liquidity in the market drops as there is not enough traders available to complete transactions.
If you put the volume tool on MT4 you can see how the activity drops during times when currencies are not actively traded.
The blue lines I’ve put on the chart of EUR/USD above shows the low periods of activity in the market. After the US trading session ends the volume drops off significantly and doesn’t pick up again until the beginning of the European Trading session the next morning. These low activity periods are when the market is said to be iliquid and the ability to buy and sell currencies without adversely affecting the market price is very low.
How Do The Banks Trade ?
Knowing how traders is one of the primary components of order flow trading.
This understanding begins with knowing how banks and other large institutions place trades into the market. The banks trade very differently to how us retail traders trade. Not necessarily in terms of what trading strategies they use to make money from the markets, but the condition’s that must be present in the market in order for them to be able to actually place trades, close trades and take profits.
Its funny, us retail traders never think about who’s on the other side of our trades, In order for a trader to place a trade into the market another trader must be taking the opposite trade, if you place a buy trade someone must be selling otherwise no transaction can take place.
Whilst this has virtually no meaning for us as our trades are really small, for the bank traders, having enough people on the opposite side of the market is of massive importance.
The bigger the trade the bank would like to place the bigger the amount of opposite orders needed in the market. If I wanted to place a sell trade on AUD/USD which totaled 4 million, I would need buy orders in the market which totaled 4 million, if there isn’t enough buy orders in the market only part of the order would be filled.
If there was only 3.5 million buy orders in the market only 3.5 million of my sell trade would be placed, the market would then begin to fall as all the buy orders have been consumed. How far the market falls depends on where more traders decide to place buy trades, because remember, we still have 500,000 sell orders that have not been filled against 500,000 buy orders, this is the slippage I was talking about earlier.
3.5 million of my order was placed at the price I wanted, the other 500,000 was placed at a completely different price as their was not enough buyers to complete the transaction.
The banks will always manipulate the market as much as possible in order to get lots of retail traders to place trades in the wrong direction, this is so they can place their own huge trades using the orders generated by manipulating the market.
Block orders are one way bank traders place trades into the market with very little impact on the actual market price.
It’s important to understand large traders do not want their trading activity to be seen in the market, this means they have to find sneaky ways to place trades.
The basic idea behind block orders is instead of placing one massive trade into the market which would have a big impact on the market direction very quickly, the total position size of the trade is split up into lots of smaller trades, this accomplishes two things.
The first is its far easier to place many small trades into the market than it is to place one big trade as less opposite orders are needed for the trade to actually be placed, and second, the intentions of the trader or entity placing the block order are masked. The traders who may have been able to take advantage of knowing a large order is coming into the market ( as this does provide an informational advantage to those who have it ) will not be able to tell the difference between a normal trade and the block trade which has been split up into smaller trades.
Understanding how people trade is key if you want to have a long career trading the forex markets. All beginners should start with the basic knowledge of candlesticks and support and resistance, but there will come a time when this will not suffice and your knowledge of the market will have to be taken to a deeper level, this is achieved by understanding how people trade. Eventually you’ll reach a point where you understand the market so well that you will be able determine which pin bars, engulfing candles etc are likely to work without the need for support and resistance or other types of confirmation, you’ll be able to tell this just by knowing what action traders have taken to create the candlestick you’re seeing.