The Importance of Reading the Order Flow
By Jack Broz ISSUE 703 | MAR 2008
[This article was based on Lind-Waldock webinar presented by Jack Broz on February 27, 2008. You can view this webinar at no charge by visiting Lind-Waldock's webinar archives. You can also register for upcoming webinars by visiting Lind-Waldock's calendar of events.]
The more time I spend working with new traders, the clearer it becomes to me that what these traders are missing in their quest to become profitable is the ability to read order flow. Often times, I find that these traders know more about technical analysis than professional traders who have been making a living in the pits or on the screen for 10, 15, or even 20 years.
Watching the order flow involves looking at a vertical display of prices that include bid and ask volume on each side. This is sometimes accompanied by a histogram that shows the total volume traded at each price. It is often referred to as "the book," "the ladder," "depth-of-market," and "dome."
If you use technical analysis to determine entry points for trades, you probably have found that many, many times, as soon as you get long – the market breaks. Or, no sooner do you get short – and the market rallies. Or, you enter a trade, and just watch the market chop around your entry price for several minutes. There's no reward in that trade either. How about exiting trades? How many times have you just gotten out of a position – and the market immediately races your way several more ticks?
Now, rest assured that these same things also happen to professional traders; however, they happen to the novice trader so often that the trader finds it difficult to become profitable. I propose that what the novice trader is missing is a correct gauge of the order flow, that is, what the buyers and sellers in the market are doing. I've heard many traders refer to what I'm discussing as "timing" as in, "I had the right idea, but my timing was off." It's the same thing; a trader who can correctly read the flow of bids and offers into the marketplace will be better able to time his trade entries and exits.
Example: Mini-Sized Dow Futures
I'll demonstrate a hypothetical order book for the mini-sized Dow futures with buy orders (bids) to the left side displayed in green, and sell orders (offers) to the right in red. The top price on the left side is the current bid; the top price on the right side is the current offer.
The numbers next to the prices in the book show the actual quantity at each price. For example, 42 12500 on the left side means there are 42 orders to buy at the price of 12500. If we see 38 12501 in a row on the right side, we know that there are 38 orders to sell at the price of 12501. However, keep in mind that what you are seeing (when you trade) is the live book and that the prices – and especially the quantities – will continually change. (Note: In an exchange-designated fast market, the changes in the book will be even more pronounced.
While there are strategies for trading a fast market, the purpose of this article is to introduce traders to the benefits of reading order flow; traders in the beginning stages of learning to use the order book should not trade fast markets.)
Now, what is critical is the volume of the best five bids versus the volume of the best five offers. As you read that, perhaps you're thinking, "How in the world can I keep up with something that is ever-changing?" Well, first of all, you only need to "guesstimate" the total volume of the best five bids versus the best five offers. Scan each "tens" columns of bids and offers; it suffices to say that there are more bids than offers in the book above. Therfore, we would expect this market to push higher.
Suppose the book changed to this scenario:
The first thing to look at is the Last Price – suppose 12501 is the last price. This change in the order book tells us that 12501 traded perhaps as many as 10 times (the offer volume is 10 less and the offer price traded). We can also deduce that the buyers are becoming more willing to buy: the quantity of 87 that was on the 12497 bid appears to have moved up to 12498; the quantity of 22 previously bid at 12498 appears to now be bid at 12499.
Now the book changes to:
What we see here is that the buyers have taken all the 12501offers and bid to buy more. That's bullish. Furthermore, some of the sellers at 12502 pulled their offers – they are less eager to sell than they were a few seconds ago. That is bullish – some of the 12500 bids went up to 12501 – also bullish. A guesstimate shows the bid size is still larger than the offer side, which is bullish. About the only thing that is bearish is that the size at 12505 hasn't budged.
Two minutes later, the book shows:
The first thing that jumps out is that now the offer side of the order book has the better size. This is the first hint that perhaps it's time to take profits. We also see huge size at 12519. That kind of size can be interpreted as longs looking to take profits, institutional sellers anticipating resistance at 12519, or, institutions trying to push the market back down so they can re-establish long positions.
Now, please understand that reading order flow is by no means an exact science. However, by studying the order book every day, you will begin to notice nuances – patterns – in the way market participants place orders, pull orders, etc. When you're watching order flow, you're watching every market participant – the institutions, hedgers, large speculators, and small traders.
On one end of that spectrum are the one– and two-lot traders placing orders in an attempt to establish a trade. On the other end of the spectrum are the institutions and large traders who, besides looking for trades, will use the book in an attempt to bluff other traders. An example of how they might do this is by placing large buy orders and hoping other traders bid in front of those orders. The institution will then sell those bids. In many ways it's a game of cat-and-mouse that often goes unnoticed by new traders.
As you learn what is happening in the market by watching the book, combine that insight with information obtained from studying a five-minute chart. Suppose the five-minute chart shows that the market has rallied up to 12539 twice during the session – only to fail and sag back to 12499-12502. This tells us that the market is viewing 12539 and 12499 as important areas. The key is to use the order book as trade nears those prices to determine if the market is still viewing 12539 as resistance, and 12499 as support. Continuing with our previous examples, let's say the market falls back after uncovering the 109 offered at 12519.
A few minutes later we see this in the book:
This tells us that the market is still viewing the 12499 area as support, and we can therefore look to buy this area.
Summary
Before you begin trading, do your technical and fundamental studies first to establish your levels. You will then be able to focus on the order flow as you are trading while keeping in mind your levels. After establishing your levels you can then park your order and let the market come to you. And make sure you focus on the volume actually traded, not the volume in the bid/ask columns.
Jack Broz is a Chicago Board of Trade member and President of TheMarlinLetter.com where he publishes daily analysis. He can be reached at 312-301-3300 or by email at tttdow@themarlinletter.com. Jack presented a Lind-Waldock webinar on this topic and numerous others. You can view them in these archived webinars, along with upcoming events at www.lind-waldock.com/events.
You can see the order flow on Lind Xpress®, which offers market depth for numerous markets including all those on CME Group's Globex.You can view the number of orders, quantity and price displayed. Lind Xpress is always free to download and use.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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