An Introduction to Order Flow Trading

There is a lot of confusion and dispute over what exactly order flow trading is, let alone how it can be utilized as a profitable trading method. We will be exploring these subjects in a series of articles beginning today.

What is Order Flow Trading?

Order flow trading has a very wide definition and it not necessarily exclusive to other methods of trading. The cornerstone of order flow trading is anticipating the prices where other traders have pending orders set, particularly important market participants with very large orders.

How Is It Done?

Obviously, order flow cannot be traded without “picking levels”. This is a big reason why many traders find order flow trading too frightening or intimidating to trade: traditionally, trading gurus warn their students against picking levels, admonishing them to “trade what you see, not what you think”. This seems to be good advice when you watch a chart, mentally pick levels and watch them all get blown away by the price. However, it does not have to be this way, not if you think a little more about the levels that you pick and equally importantly, if you use tight stop losses.

Order Flow Trading Methods

Many gurus teach trading methods based upon identifying likely support and resistance levels, and watching for confirming price action when the price arrives at these levels. In a sense, this is also order flow trading, as the method is based upon expecting there to be a lot of orders at these levels. However “true” order flow traders would take it one step further and not wait for the price action confirmation before entering the trade. This seems more dangerous than waiting for price action confirmation, but think about it. If you are waiting for the close of an hourly or four hourly candle before entering, just picking the level would get you in at a much better price, putting you well in profit already by the time price action traders start to enter. Another advantage of a pure level-picking method is that you can usually use a much tighter stop than you would need following price action confirmation. Additionally, the stop would be better placed.

So, how to pick the levels? That is the million-dollar question, but in my experience the really fruitful levels are obvious support or resistance formed at previous daily and weekly highs and lows. Order flow traders must learn not to be afraid to trade against the trend. Some of the best order flow trades you will see will be triggered by a very strong and seemingly unstoppable move in the opposite direction that is quite frightening to trade against. I will explain why this is so in next week's article.

Last week I began a series of articles about Order Flow Trading. We defined Order Flow trading as a wide-ranging term for styles of trading that are all focused on anticipating where large buy and sell orders would be located, and in trading along in tandem with those orders. In short, Order Flow Trading involves picking levels. I outlined how to find those likely levels: look for previous daily and weekly highs and lows, and emphasised that many of the best trades are the most frightening counter-trend trades. I will now try to explain why this is so.

An Order Flow Scenario

Let us imagine the following hypothetical scenario. It is a few minutes before 8am London time, an hour that is commonly regarded as the “London Open”, a time at which Forex volatility tends to rise dramatically. Looking at the daily chart on London time, yesterday closed very near its open, and the overnight Asian session has been extremely quiet. Yesterday’s high was 1.3100 and yesterday’s low was 1.3000, the price right now is approximately 1.3050. In other words, yesterday’s daily candle was a doji, and yesterday’s high and low are both confluent with round numbers.

We reach 8am London time and the price begins to rise sharply. After just half an hour, the strong upwards move has the price hovering just underneath 1.3100.

Some traders will look at this scenario and see strong buying pressure pushing the price up. However, a sharp move up may simply mean that sellers have pulled their orders back to 1.3100, creating a misleading vacuum that allows the price to rise sharply. As soon as the price hits 1.3100, order flow sellers who have picked this level as an excellent selling level step in with short orders, and the price falls dramatically, reaching a short profit of 40 pips within another half an hour, suffering a drawdown of only 2 pips.

Sometimes the Faster the Move, the Weaker the Move

What many experienced order flow traders will tell you is that the moves that fly quickly to the obvious levels worth going counter at are usually the best trades, because the quickness of the move is indicative of a vacuum rather than strength.

How to Pick the Levels

Of course, it goes without saying that a simple strategy of fading every previous daily or weekly high is, over time, unlikely to prove very profitable. A certain amount of discretion needs to be utilised in picking the right levels at which it is worth getting involved. Note that order flow trades do not need to be counter: you can wait for levels to be broken and retested before trading them in line with the trend.

Here are a few tips for picking pairs to trade and the levels at which there is likely stacked-up order flow:

Choose the most liquid pairs. At the moment the best pair for fading levels seems by far to be EUR/USD, although it does not move very far.

Pick levels with confluence of more than one recent previous daily high or low and trend lines, round numbers, or pivot points.

If the pair has already made a typical day’s range, that is a good sign.

If the pair reaches the level without hitting any other obvious level during the most liquid part of the day, this increases the probability that it will be a good fade trade.

Use tight stops, as the really good trades will usually not exceed the level by more than a few pips.

Look to protect or lock in some profit after the trade goes about 40 pips (with EUR/USD) in your favor.

This kind of counter trend trading is best practiced in conditions where the daily charts are consolidating and there is no obvious trend.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.

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