Beginner’s Guide to Order Flow Trading

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The first time new traders learn about order flow trading a light seems to come on. I’ve been trading order flow for 20 years now and though the setups and strategies have changed some, the core philosophy hasn’t.

I created this guide for those who are interested in Order Flow Trading but don’t know where to start. You’re about to discover a new way to think and view the market as well as where you should focus your efforts if you want to get serious.

Picture of Order Flow Trader Who Is Excited and Technical Trader Who Is Frustrated

What is Order Flow Trading

Order Flow Trading is a type of trading strategy where trading edges are defined through the analysis of advertised orders and/or executed orders. Order flow traders look to profit by capitalizing on market imbalances.

This my own personal definition for order flow trading. It’s become a “buzz” word online by all of the trading gurus yet nobody seems to understand or define what it truly is.

There’s two different forms of analysis when it comes to order flow trading. On one end of the spectrum we have the analysis of executed orders and on the other end advertised orders.

Executed orders are trades that actually took place between a buyer and a seller where as advertised or resting orders are the advertised bids and offers (resting orders).

We use different tools and indicators to analyze the data which we will look at shortly.

As technology has advanced over the years so has order flow trading. Let’s take a brief look at the history of trading order flow as I think it helps give you a unique perspective as well as some realities about day trading.

Order Flow History

Order Flow Traders in Pit

Order Flow Trading really began back early on in the bucket shops and pits of the exchanges.

Pit traders use hand signals and vocal “open outcry” to relay their orders to market makers.

Interesting Fact: The bright colored coats you would see people wearing on the floor would assist in the identification of specific traders or the exchange members for whom they work. The standard red was given to traders (also called locals) and brokers on the floor, but many opted for their own distinct jacket designs worn by their entire group.

I can still remember when I first stepped foot on the floor of the Chicago Board of Trade in 2002. I was a junior in college and the experience for me was absolutely electrifying. Ultimately it would set me on a path for my entire professional life.

In order to be a successful trader in the pits you had to be an expert at reading the crowd and the moves of the larger players, all while keeping your cool and managing your emotions in a very chaotic environment.

Pit traders were literally in the heart of the order flow. The pulse of the crowd would drive the decisions of locals to buy or sell.

As technology advanced, more and more volume left the floor of the exchanges and went electronic. The advancement of algorithms were pretty much the final nail in the coffin for floor traders as volume dried up.

A lot of floor traders failed to ever make the move to electronic trading. The good ones had mastered the psychological side of the business, but the game had changed.

Along with the technology came a leap in advancement on analyzing trade data. One of the first major leaps was the introduction of Level II Quotes. Level II quotes had been around for decades, but access to them wasn’t simply a matter of going to website and paying for the data.

TSLA Level II Quote

Level II quotes displayed all the bids and offers for each price level from every ECN (electronic communication network). I started my professional trading career in 2003 as a level II trader.

At that time the Level II became the hear of order flow trading similar to the traders in the pits signaling their bids and offers to the market maker. It brought market demand and supply to life.

When I began trading, that was enough of an edge on it own to make a lot of money. However, like all competitive industries, technology lead to rapid advancement.

In 2008 trading algorithms tipped the scales and began accounting for the majority of trading volume. This made it difficult to read a level II as orders were constantly pulled and added to the book. It became very difficult to rely on a level II alone for an edge.

Like the floor traders, I had hit a point were I had to adapt and develop new edges or I would be looking for a new job.

At that point in my career I began to study volume analysis in great depth which has led to where I am today as a trader.

A lesson to to take away is like any competitive industry, advancement is rapid. If you want to make it long term in this business you constantly have to be looking to improve and better define your edges.

The core philosophy behind order flow trading is auction market theory.

Auction Market Theory

Flow Chart of Auction Market Theory Phases Including Fair Value, Imbalance, and Discovery

Auction Market Theory is a philosophy that financial markets move higher and lower due to imbalances between buyer and seller aggression (caused by market events) until price discovers a level where aggression is balanced and the most trade can be facilitated (Fair Value).

Auction Market Theory is the heart of order flow trading.

When you begin to incorporate AMT into your core principles and strategies you will begin to feel more empowered as a trader. I believe you become better at reacting to market data and events rather than trying to predict them in the traditional technical sense.

Order Flow Trading Strategies

eMini S&P 500 Volume Imprint Chart With Cumulative Delta, Nyse Tick, Time & Sales, and DOM

The ultimate goal of any order flow strategy is to determine if the market is balanced to profit off ranges or imbalanced to profit off trends.

This is done by focusing on data generated either from executed orders or advertised orders. Let’s take a look at some of the tools and order flow indicators used to analyze the separate data types.

Tools/Indicators – Advertised Orders

Level II Or Depth of Market (DOM)

eMini S&P 500 Depth of Market
Level II Quote of Microsoft (MSFT)

First we have a Level II Or Depth of Market. We use a DOM to analyze areas of high and low liquidity in the book and to help evaluate the aggression of buyers and sellers at different price levels. This is the modern form of reading the tape.

There’s no shortcut to mastering reading the tape. It takes experience, which as a trader means extensive screen time. In time, you will notice how price moves through different levels of liquidity.

Every instrument you trade will have different characteristics. For example, a high flying meme stock or volatile stock like Tesla will have different characteristics than a company like Microsoft.

Time & Sales

Time & sales indicator lists every trade by it’s transaction time, volume, and price.

It’s used to spot large orders and gauge the speed and flow of the market.

Similar to a Level II it will take experience to learn how to read time & sales and every instrument will have it’s own unique characteristics.

Liquidity Charts

Liquidity charts display bid and ask orders in a visual manner.

The chart seen above is from Bookmap’s charting software, which specializes in liquidity charts. The goal of these charts is to help you interpret areas of high liquidity (resistance) and low liquidity where price is more likely to move through quickly.

We will discuss a number of platforms that haves similar features shortly.

Tools/Indicators – Executed Orders

Volume and Volume Profiles

Volume Profile Outlining Point of Control, OHLC, and High and Low Volume Nodes

Volume and volume profiles are the backbone areas of focus for all of my strategies. I interpret volume data and profiles to determine if a market is balanced or imbalanced, the strength of trends, determine reversal points, and much more.

If you’re new to order flow this is where I would focus your efforts to start.

Market Profiles

“The Market Profile is a unique charting tool that enables traders to observe the two-way auction process that drives all market movement—the ebb and flow of price over time — in a way that reveals patterns in herd behavior.” ~ James Dalton

I couldn’t give a better description than the famous author on market profiles James Dalton. Market profiles deserve their own guide, which I will publish soon.

Below I mention a few books of his you should checkout.

Delta

Volume Delta measure the difference between buying and selling power. It’s calculated by taking the difference of the volume that traded at the offer price and the volume that traded at the bid price.

Cumulative volume delta simply plots the delta values for each candle on a graph.

Delta allows you to gauge the strength of a move by analyzing the aggression of buyers and sellers by their use of market orders.

Delta plays a large roll in my scalping but I believe it can be beneficial to longer term traders as well.

Next, let’s take a look at some of your charting options if you’re interested in order flow.

Order Flow Charting Software

Here’s a list of the most popular order flow charting platforms.

MotiveWave.com – The software I currently use.

SierraCharts.com – I used Sierra for almost a decade. Super fast and robust as long as you don’t mind the dated GUI.

NinjaTrader.com – Widely used by traders look to do automation.

QuantTower.com – Personally not familiar with them but I’ve read good things.

Bookmap.com – Bookmap specializes more on advertised prices and liquidity based on that data. Check out there platform and you will see what I mean.

Order Flow Education

The following guides and posts area good primer to get you started.

Order Flow Trading Books

James Dalton and Peter Steidlmayer are considered the best authors when it comes to market profile and volume techniques. The books listed below are classics that should added to your reading list.

Book Cover - Mind Over Markets by James Dalton
Book Cover - Markets in Profile by James Dalton
Book Cover - Steidlmayer On Markets by Peter Steidlmayer

Conclusion

It’s my belief that order flow trading teaches you a reactionary style to the markets rather than predictive. It helps you build confidence as a trader seldom leaving you wondering.

The tools and topics covered here will take time. Experience is truly the only way to master any subject and the only way you do that with trading is screen time. You have a lot to learn, so get going!

If you have any questions make sure to leave a comment below!

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