Order Flow Trading

What is order flow trading? In order to define order flow trading one would first need to delineate exactly the type of trading one is discussing. There is quite a bit of dialogue about order flow trading and misperceptions abound as to the most efficacious manner in which to use this trading method. 

Some describe order flow trading as directional trading, i.e., you are betting that prices will either move up or down. If you believe a currency pair will go up, you will execute a buy order, going long. If you believe a currency pair will fall, you can sell it, shorting the trade.

Order Flow-Transaction Flow Order flow can also be referred to as transaction flow. Transaction flow takes place when someone believes the price of a security will move and then executes an order in the market. The individual can do this in two ways. He can take an aggressive approach by executing a market order and paying the spread. Or he can enter a limit order or stop order specifying  that the execution of the  transaction should take place at a certain price (limit order) or executed after the market hits a certain price (stop loss order). These are both considered order flow trading methods.

In fact, the basic tenet of order flow trading is being able to forecast the prices prominent traders will elect and setting up a position where you can take advantage of that order flow. As can be expected, the market will only move significantly when there is sufficient market orders in place and large buy and sell orders await execution.  This requisite to uncover specific patterns or trends and to constantly anticipate what other market participants are doing can often lead to greed in the market.  It may also create an anxious environment for beginner traders who are intimidated by the need to watch for these levels.

There are many who feel that Forex markets are controlled by big banks and financial institutions and that it is up to the new as well as the experienced individual Forex investor to determine accurately the order flow in the markets in order to ensure that their trades are in synchronization with that of the big banks and institutions. Since these big institutions are at the receiving end of giant players such as Bank of America and Merrill Lynch, they will always control the direction of the markets and it would be prudent for novice and small traders not to trade against them.

Under these circumstances, the question remains: How do we determine Order Flow? The long and the short of it is this: It all depends who is making the determination. A technical chartist, for example, has the ability to look at a Forex pair chart and immediately spot the likelihood of a pair moving up or down. How does he spot these moves?

He uses a MACD indicator. Moving Average Convergence Divergence is a technical analysis momentum indicator used to analyze financial markets. The indicator, like the name suggests, measures the convergence and divergence of moving averages. A MACD is most often used as a lagging indicator that mimics the behavior of any traded instrument. However, it can also be used as a leading indicator, predicting the direction of the instrument in advance of any profitable move. 

Using S/R Levels On the other hand, many trading mavens focus on identifying likely support and resistance levels before trading. They recommend observing the price action when price reaches these levels. This can be understood by some as a type of order flow trading but true order flow traders would look beyond the price action and would not wait for price action confirmation before entering the trade.

Using this method of s/r level identification may seem more precarious than waiting for price action confirmation. But that isn’t always true. By using the pick-a-level method you can usually employ a much tighter stop than you could if you were just following price action. You could also get a much better price on certain trades and find yourself in a much better position by the time price action traders begin to enter the market.

So how does one go about choosing these levels? Picking the levels is where the difficulty comes in when discussing order flow trading because there is simply no one satisfactory answer to this question.

One way is to observe the obvious levels of support or resistance from the previous daily and weekly highs and lows. At the same time, order flow traders must know that they do not always have to go with the trend and that many a time, a strong and unrelenting move in the opposite direction can activate the most profitable order flow trades.

Picking the Levels Of course, it goes without saying that this strategy of consistently shadowing the previous daily or weekly high is unlikely to prove very profitable over a period of time. It takes more than that to pick the right level and a good deal of judiciousness is called for in order to understand which levels are worth getting involved with. Interestingly, with order flow trades, levels can be fractured and tested anew before trading them in tandem with the trend. No counter is required.

Experienced order flow traders, however, believe that some moves shoot up speedily to certain levels and that these are often the best trades to make because the rapidity of the action suggests a void rather than strength.

Tips of the Trade Knowing which Forex pairs to trade and at which levels they are likely to be considered hefty order flows requires experience and patience. Here are a few tips that can help:

Select s/r levels where more than one recent previous daily high or low converges with pivot points, round numbers or trend lines.

Using tight stops is worthwhile as the really sound trades will usually not exceed the level by more than a few pips.

Don’t be greedy. Lock in some profit after the trade goes about 40 pips (with EUR/USD) in your favor.

Adam is a Forex trader who has worked within financial markets for over 12 years, he is also the Chief Instructor of FXacademy.com

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