Order Flow (lesson21)

How to Use This Information 

First, determine the current sentiment.

Example: The market bias for the Pound is currently very negative and GBP/USD is clearly trading in a downtrend. I therefore will only look for opportunities to sell the pair.
Second, note key price levels. These include bids and offers from the resources I will post below and key technical levels (standard support/resistance levels). Third, watch for price action to give you a high probability opportunity to enter short. I will cover later some of the various Order Flow techniques. For now, I just want to note that you should always use flow information like bids and offers with caution. You want the market bias to be in your favor and wait to see a reaction to those levels, not enter ahead.

I hope I have emphasized enough how important it is not to use them as trade signals, so I will post now the resources I use for the flow information (they are free):
ForexLive

Participants in the FX Market 

Before we dive further into the world of Order Flow Trading, we must be aware who participates in the FX market. While not all groups have the same characteristics, there are some most have in common. I will split the groups up and explain them all in more detail.

Dealers Sovereign Names
Large Speculators
Real Money
Commercials
Retail Traders
Dealers

Dealers are the main market makers for the FX market as they operate on the "Tier 1" level - the interbank market. A dealer quotes his customers a bid and an ask price and the difference (the Spread) will be his profit. As a transaction with his customer takes place, he takes the other side of the trade and can either get rid of his exposure via the interbank market or he can hold the trade if he thinks it will benefit him. Dealers therefore can hold trades for speculation, but they usually close them in a short time period. They mostly finish their trading day without any open positions. Dealers are well-informed traders and have a good sense for short-term market movements, so it only makes sense for the banks to let them also do some discretionary trading beside handling customer trades. They participate in stop hunts, as I explained earlier in the thread, because they look to manage their book. The network of dealers working for the top FX market-making banks build the "Interbank Market", the highest tier in the FX market.

Sovereign Names

This group includes central banks and institutions like the Bank of International Settlements (BIS). Central banks operate in the FX market on a daily basis and when other participants become aware of their presence, they will pay a lot of attention to what they do. Asian Central Banks are one group within the Sovereigns that are often identified in the marketplace and news providers like Reuters are reporting about their business. Especially if things are rather quiet, they can have a strong influence, so keep that in mind! The "BIS" is an institution that handles transaction for other banks. The idea is basically that other CB's can operate in the market without being identified. Nevertheless, any mention of "BIS" or "Basel name" in the news feed is worth paying attention to.

Large Speculators

Those are hedge funds, model funds (algo & HFT trading) and large traders. They are in this game for the profit and are the group with the greatest variety amongst members. Some trade intraday, some exclusively long-term and some combine all of this together. Model funds mostly focus on automated trading and volatility is something they love. Most of the hedge funds however, will look for stable trends to ride, like the current GBP and JPY downtrends. As they are leveraged players, they can feel the pain sooner when a squeeze is happening in the market. It is certainly not just the retail traders getting stopped out, large specs can be caught with a vulnerable stop loss too.

Real Money

They are called that way because they do not use leverage. Included in this group are mutual funds, classical investment funds and sovereign wealth funds. They are conservative and will generally either look to manage their currency exposure or, if speculating, look for stable trends. Hedge funds do too look for trends, but they have the ability to leverage up and switch to short-term trading if they wish to. As you'll understand, real money funds that do not operate on leverage and cannot get aggressive, will not be able to operate that way. Real Money will be usually a bit late in a move, but their presence is still worth noting, as they look to accumulate positions.

Commercials

Commercials (or corporations/businesses) are looking to hedge their currency exposure they have through their business operations, mostly due international business. Managing their risk is the number 1 task for them and not profits from speculation. Their activities can have an impact on the markets if they are trading in a big size, but they are not participants one should follow, as they are not profit-motivated in the first place.

Retail Traders

The number of retail traders that lose is hard to guess, but it is definitely high. The popularity of Technical Analysis (TA) led them to place their stops at predictable places and this can be exploited by Order Flow Traders. Even as the number of proven trading strategies shared free has increased over time, most retail traders lack the consistency and discipline to make it in this business. I hope that gave you a good insight who's operating in this market and some of their common characteristics.

Reading Order Flow

There are several services that provide real-time flow information like the one's I mentioned above. Again, they have to be used with caution as orders can get cancelled or can have little or no impact. Also, we don't want to get too dependent on them. Imagine a service get's discontinued - you want to be able to do your own order flow analysis and not let yourself be distracted by this. Reading order flow is possible on charts and you don't need the flow info services necessary.

This is how the standard flow info looks like:
Bids at 1.3000, 1.2980, 1.2950
Offers at 1.3050, 1.3080, 1.3100

Most of the reported levels are one's that have cluster of orders at or near it. From the above mentioned info we could say that there is buying interest (demand) at 1.30, 1.2980 and 1.2950. The further the level, the more interest we can expect, as traders will feel comfortable buying "very low" or selling "very high". Remember that price action can influence sentiment too. If we see EUR/USD breaking below a key psychological and technical level, some traders will sell on the break (i.e. momentum funds) and with stops getting triggered on the way, this will drive price further lower.

Orders can either: Get "eaten" along with little or none impact (this is common during a stop cascade/squeeze)
Cause a slow down in momentum; price will consolidate
Cause a reversal (common during times of low liquidity)

When trading of reported orders, I recommend waiting for a reaction and not putting a limit order ahead. See how price reacts to the level and how it behaves it after it hits it. Let's say price trades down to 1.2950, where we have reported large bids from various participants. We see price stops at the level and retraces back up. Now, how does it behave on the way up? Does it seems that there is real momentum building to the upside or are rallies hitting quickly into fresh selling? Reading the order flow directly is a bit tough in the beginning and it is hard to explain it in words. You have to monitor price action as it happens and take notes. Combine this with sentiment and you have a real advantage.

Sentiment will give you the biggest advantage. Like I mentioned in my last post, you don't have to make it complicated. Note key factors that are driving price action currently, analyze price action itself and keep track of how they correlate. Let's take the Aussie Dollar as an example. Sentiment is positive as the RBA indicated it will not cut rates in the near future and on better economic data. Price action confirms this, so we want to look for reported bids and wait for a reaction. Nothing works all the time, but with sentiment on your side, you'll go with the side of least resistance.

What really turned my trading into a profitable business was focusing on the high probability trades. They don't require a huge stop and the reward is clearly worth the risk. Market profile is another factor. During times of low volatility, playing the range is the best strategy. Let's say we are trading in a 1.2950/1.3020 range in EUR/USD and there is no clear sentiment.
You can anticipate a reaction to the reported levels and fade any rally or drop back to the mid range level. When volatility is high, bids/offers can get consumed along the way quickly and that is an environment where you definitely don't want to pick a top/bottom. When there is real strength behind the move, look to join the momentum and not fade it. In combination with the reported levels, you can identify key supply/demand levels on the charts. Previous day high/low, previous week's high/low, previous week's close level and psychological levels (big figures - i.e. 1.30, 1.31).
Start to "read the flow" on the charts and you'll get better at it with time. Stops are also easily identified on the charts. Just think what the technical analysis guides taught you. They taught you to place your buy stop above the big figure (i.e. 1.30 -> stop at 1.3010) or your sell stop below the big figure (i.e. 1.30 -> stop at 1.2990). Or, above resistance/below support.

Barrier Options

Barrier options are exotic derivates and an option on the price of the underlying asset. The option writer (typically banks) sell options to the option buyers. FX Options are traded over-the-counter and not on exchanges. If the option expires worthless, the option writer has earned the premium (similar to a comission as you enter a trade) and the option buyer has lost. If the option is in-the-money, the option writer has to pay out the option buyer the specified amount.

There are:
Knock-In Options - the option is worthless until the underlying asset hits the specified barrier price in the set time period. Example: EUR/USD spot price is 1.28 and I buy a 1.30 knock-in option. The option is worthless until it breaks above the 1.30 level.

Knock-Out Options - the option becomes worthless if the specified barrier level is hit. Example: GBP/USD spot price is 1.51. I think the pair is heading higher, but do not expect much volatility. If I buy a G/U option with a barrier at 1.53 and it does not reach the price level in the specified time period, I get paid. However, if price breaks above 1.53, the option will become worthless.

Double No-Touch Options -Just like the knock-out option, but it has two specified barrier levels. Example: DNT option for 1.26 / 1.34 in EUR/USD. If price stays within the set range during the stated time period, the option writer has to pay me the specified amount. However, if price breaches any of these two barrier levels, the option will become worthless.

Double One-Touch Option - Knock-in option with two set barrier levels. Example: GBP/USD 1.46 / 1.54. I will get paid on the option if it reaches either of the two set barrier levels during the specified time period. If it does not, it expires worthless.

Why does it matter?
Barrier options can trade in decent size, there are sometimes ones in the value range of 500 million up to 1.5 billion. Let's use an example for the Knock-Out barrier option, as it the more common used one. Put yourself in the position of the option writer. You sold a 1.27 / 1.34 DNT barrier option to a customer with a 500 million $ payout. Price is approaching the 1.27 level and that is exactly what you want to see. Once it hits 1.27, you have pocketed the premium and will keep the half billion. This is why option desks will gun for these barriers and try to get them triggered. Similar to the FX spot dealer, you want establish a short position and increase downside momentum. As there are often stops located above/below barriers, this will help to attract the attention of Spot dealers and of predatory traders gunning for the stops

On the other side, there is the option buyer that has great interest to keep price away from the 1.27 level. Not everyone can buy a option in that size ($500m), so you can be sure he's got some firepower too. He will try to buy ahead of the level and hope there will be also other bids in decent size. A good example is the 1.28 barrier option in EUR/USD that got triggered today. The option buyer was lucky yesterday, as there was decent demand from Asian Sovereign names and corporates that kept the pair above the barrier level. However, EUR-negative sentiment led to fresh selling this morning and the pair broke below 1.28. When we talk about barrier options in decent size (at least, larger than $50M), they certainly can have an impact on markets. However, I don't want this to look like there is a battle whenever a barrier option appears. Just to mention one reason, there are participants that simply don't care about some barrier option, they are gonna execute their trade idea nevertheless.

Some things to keep in mind:
The "battle" will be more intense if the expiry is near. If the 1.27 barrier option in EUR/USD expires in two days and we are approaching the level, there will be very likely some effort from the option writer to get price down there and from the option buyer to keep price above for these two days. On the other side, if the option expires in two months, but it seems very likely we will break below 1.27, defence from the option buyer will be minimal. Sentiment & Market Profile! If we get bad news from Europe, there will be a lot of selling coming in and nobody's gonna care about some barrier option. The option buyer will most likely also see that it is not worth defending the barrier - why additionally waste money?

How to use this?
Note reported barrier options (ForexLive) and establish a position to push into the barrier level. Preferably, go with sentiment. Example: There were 1.28, 1.2775 and 1.2750 barrier options reported and sell stops reported below them. One could not have a more beautiful OF trade: Establish a short position and gun for the barrier and stops below. Given the average daily range of EUR/USD, 1.2750 would've been a realistic target. But a good approach would also be to establish a position and take partial profits as each of the barrier gets triggered to your final target. In general, it is more preferable to go with the option writer and attack the knock-out barrier, especially when sentiment favors such price action. However, in a market environment with little volatility and tight ranges, barrier protection can be stronger.

There a few key things you need to keep in mind about the accumulation of stop loss orders in the markets:

1) The higher the timeframe, the higher the number of market participants being aware of a certain technical pattern and placing orders based on it. Simply, more traders will notice a pattern on a 4-hour chart than one on the 15 minute chart. There is a lot of noise on the minutes charts and not many traders will bother with interpreting too much into it.
2) The larger the number of confluences, the larger the size of the orders If a key resistance level happens to be near the 200 simple moving average and the 50.00 % Fibonacci level from a key market swing (i.e. drawn from the monthly high to the monthly low), it will get even more attention and orders around it will be larger.
3) The longer a pattern exists, the larger the size of the orders Let's say we have an established range in EUR/USD between 1.30 and 1.32. Limit orders will start to cluster at both levels and stops will be placed below 1.30 and above 1.32. The longer the range exists, the larger the stops will grow until one side finally cracks and triggers the stops.

How to Mark Large Stop Clusters on your Charts
1) Open a blank chart - start with the Daily chart
2) Note key support and resistance levels on the Daily and note at which price level the 200 SMA is trading. If you wish, draw a Fibonacci retracement from the latest major swing low to the most recent major swing high.
3) Move down to the 4H chart and again note the key S/R levels. Mark them in a different color
4) Switch to the 1H chart and repeat the process, noting minor S/R levels. Again, draw them in a different color than the previous ones, so you can regonize them more easier. Here is an example (EUR/USD)

Market Squeezes

You have probably already heard the term "squeeze" in financial markets. It describes a market where traders are caught overly positioned to one side, which leaves them vulnerable to sentiment-changing events or large players taking advantage of their vulnerability by engineering a "technical" squeeze.
 A squeeze can happen:

1) as a result of an event that has changed short-term sentiment. A very recent example is the USD/JPY squeeze we saw the last night in the Asian trading session. Traders expected that the Japanese Prime Minister Abe and his party will win the majority in the Upper House election - which they did. However, this was already priced in as many traders bought the USD/JPY on Friday on those expectations. This resulted in a squeeze of the traders who were positioned long. Those who where long, took profits, and some predatory traders joined the selling to profit from the move. Once the stops below 100 started to getting triggered, downside momentum picked up until we ran into good-sized bids around 99.60.

2) due to technical reasons. Large players can engineer a short squeeze without an event to gain more favorable conditions for themselves. This is most commonly seen as a stop hunt, as the stops from those short-term traders are usually triggered in this process. You have to keep in mind that it is the job of financial journalist to always find a reason why a certain price move has happened. So if you notice that there is really no reason why a certain pair moved, but you are aware of the fact that positioning is either overly long or short, you can imply that this was simply a stop hunt.

How to take advantage of a market squeeze:
1) If there is no reason for a certain price move and you are sure it was only stop loss-driven, you can fade the move and trade in the direction of the trend/sentiment. You could of course join the squeeze and try to hunt the stops, but you need to be quick.
2) The squeezes that happen due to an event that has changed short-term sentiment or even medium-term/long-term sentiment endure longer and you can take advantage of those trapped traders that are caught on the wrong side by joining the squeeze. For example: Let's say the RBA (Reserve Bank of Australia) does not cut interest rates in August. The majority of traders expected they would do so and positioning is extremely short. What will happen? We will see a larger short squeeze driven by position covering and stop loss triggering.


Trader Alen