Order flow trading is probably one of the oldest methods of trading, which is about forecasting where big traders are placing their orders and generating trading decisions based on others’ positions. It is an estimation of the direction of market movement and how the trades of big brokerage houses/institutions are affecting the market. In this regard, it is more of an understanding of the market, rather than being a strategy.
Order flow trading requires identification of an ideal trade locations and cashing on the opportunity. It is generally done using the order books, which are essentially an electronic list of Buy and Sell orders, arranged as per price time priority. The size as well as the price of these orders is mentioned in the order book, which becomes a great tool to analyse the market direction.
Being "In Trend"
Stock markets have always been dominated by traders who try to follow the trend. They meticulously study the market movement and pick up patterns, from which they hope to generate positive returns. During the inception stages of the stock markets, traders preferred gut instinct to analyse the underlying truth behind the price movement, due to lack of sufficient data points.
However, with the advent of digital trading and evolution of technical analysis, several tools are now available in the market, which captures the motion of price based on parameters like 200-day moving average, Fibonacci, candle stick price, etc. For a keen eye, these order flow analysis tools are extremely relevant to understand the market auction as well as sentiment Therefore, a strategy rooted in understanding order flow will always be backed by spotting the trends.
Types of Orders
Order books are extremely dynamic in nature, and updated in real time intraday. All order-driven markets use order precedence rule and trade pricing rule.
A Market Order is an order to immediately buy or sell the stocks at the best available price. An example of market order leveraging strategy is the Moving average (MA), which weeds out the ‘noise’ or random price fluctuations of the market. When the price crosses above or below a moving average, a potential change in trend is observed and can only be traded through market order.
A limit order is an order to buy or sell a given quantity of stock at a specified limit price or better. A limit order book represents the remaining orders standing at various price limits post the execution and cancellation. Although the limit order offers a better price than a market order, there is no guarantee that it will be filled. The probability of filling a limit order is referred to as the Execution Probability. Major exchanges in the world including Tokyo, Hong Kong and Australian Stock Exchanges operate under the limit order driven system.
How to trade with Order flows
Know where to trade
Identify the Trade locations
Trade locations are where the large institutions are buying or selling. It is important to identify these areas as a trader who goes by order flow will trade there. This can be done by using several available tools on the internet, one of which is NOFT’s Institutional Edge System. The following is a screenshot of the system
Through this, it is also easy to identify the areas where large institutions have stepped in the game, by creating volume composite indicator or Ghost Block. That ways, a trader can locate the most profitable locations, where the trade can be entered.
Source: Ghost Block NOFT
The important thing here to note is that all these analysis can be done pre market, which gives the trader advanced knowledge of where the institutions have parked their money or willing to take risk.
Know when to trade
Using Order Flow
Order flow tells us when to trade. A trader can use an order flow sequence tracker (OFST), such as the following, to analyse a candle. It gives good information regarding the aggressive buyers and sellers. These OFST has multiple real-time signals, like the “unfinished business”. It is signal where a candle is not completely finished, which can be eventually studied to identify scalp trading opportunities. This information flows to the trader intraday and is based on order flow sequencing. Similarly, block trades are indicative of large scale institutional involvement and high volume areas. Therefore, using order flow, a trader can determine the entry points in the trade.
Reduce Risk and Boost profits
Once a trader has entered the trade, the most important thing is to plan an exit strategy. Therefore, it is important to have a trade management system like the institutional money flow tracker which points at the risks and tells the trader when and where to exit. This tracker monitors the activities from the time a trader enters the trade. It also calculates all the ‘buys’ and ‘sells’ to arrive at a Cumulative Delta. If the delta is positive, the trader continues to go long or otherwise exits.
It is absolutely essential to understand how the market behaves if there is an intent to pursue a long career in trading. Of course, basic knowledge of candlesticks, support and resistance, etc would come in handy, but to analyse the markets deeper, order flow analysis needs to be done to identify the key points. Intensive research work has been done in this direction, especially in limit order books, which digs deeper into pricing mechanisms.