Understanding Order Flow in Forex

[RichardCox 10]

Understanding Order Flow in Forex

 

Once forex traders have spent some time researching the market and in developing technical analysis techniques, it can be easy to assume that some of the basics have already been covered and no longer need to be explored. But this is an outlook that can create an increased potential for problems and lead to losses that might otherwise have been avoided. No successful trader ever feels as though he has masted all levels of the market and it can often be a good idea to revisit some of the market elements that might seem basic in nature. One of these elements can be found in the process of order flow, and this is a market element that can have massive influence on the trend activity that is likely to be found in in the future.

 

Active Buyers and Sellers

 

First, it should be understood that the market is simply a collection of buyers and sellers. When a trader enters the market and buys an asset, the active and available supply of that asset is reduced. When a trader enters the market and sells an asset, the active and available supply of that asset is increased. Rising supply levels are bearish for asset prices. Falling supply levels are bullish for asset prices. So when we are seeing positive trends we can understand that a majority of the market is making its position clear and this is what is sending prices higher.

 

But it is possible to follow this logic further, as it does not only to apply to positions as they are opened. For example, a long position that is closed has the same market effect as if that trader has just opened a short position. A short position that is closed has the same market effect as if that trader has just opened a long position. For this reason, we tend to see retracements in market prices after considerable trending moves have been made. In an uptrend, this means that bullish traders are taking profits on long positions. In an downtrend, this means that bearish traders are taking profits on short positions. These events are what prevent trends from continuing ad infinitum, and this is the activity that defines the dynamics in most trading markets.

 

Option Expiries

 

Another factor that can has a massive impact on market prices is option expiration. A proper options tutorial is beyond the scope of this article. But it should be understood that options contracts are defined by an expiration period that ends the life of the position. There are many different options expiration times but there are often significant options orders that are closed at the end of a week, month, or quarter. This is significant because it tends to increase volatility in the forex markets during these intervals, and when traders are aware of these instances it can be easier to avoid significant surprises in market movements.

 

For example, let’s assume that a major hedge fund has purchased call options in the Euro as a means for hedging risk in its Euro-denominated assets. These call options essentially represent a long position in the market, so the hedge fund needs the Euro to rise in order to gain profits in the position. To accomplish this, the hedge fund might buy the Euro near a major support level in order to prevent the market from falling below the strike price of the option. Hedge funds are typically able to command position sizes that dwarf the capabilities of individual traders and order flows of this size can lead to unexpected price moves in the market. This does not necessarily mean that forex traders should avoid positioning themselves in the market but it does mean that it is generally a good idea to keep position sizes smaller in situations where options expirations are likely to have a bigger impact on trending moves.

 

In many cases, these situations will be alerted in the financial media. So, if you actively read the news wires that are most closely dedicated to your chosen trading assets there will probably be signals sent which suggest that hedge funds are actively establishing these types of positions.

 

Central Bank Activity

 

To be sure, hedge funds make up a very important section of the market. But an additional factor that many investors might not come from the impact that is seen when central banks place order flows in the market. Central bank order flow activity influences the forex market in ways that are much more pronounced than what is seen in areas like stocks or commodities. This is because central banks will directly buy and sell currencies in order to either restructure its balance sheet or to specifically influence certain sections of the market. This latter scenario is referred to as “currency intervention” and this type of event has created some of the largest percentage moves in the history of the financial markets.

 

Chart Example: EUR/CHF

 

 

Source: Yahoo Finance

 

In the chart above, we can see a recent example of this using the EUR/CHF. The sharp declines that are seen in the middle of this price history (January 2015) were propelled by a decision by the Swiss National Bank to remove its established price floor in the CHF relative to the Euro. This led to a sharp surge in the value of the CHF as the decision implied that the SNB would no longer be selling its currency in an effort to depress its value. This lack of “resistance” from the SNB would then enable traders to buy the currency without fear of central bank intervention into the forex markets. The result was a massive decline in the EUR/CHF (positive for the Swiss Franc) and many traders positioned in the other direction were forced to deal with margin calls.

 

Events like this are rare but central bank influence is not as central banks all over the world actively buy and sell currencies on a daily basis. Market outlets like Mocaz are highly efficient in alerting traders when these types of activities occur, so this type of information is something that should be on the radar of all forex traders that tend to base positions on shorter charting timeframes. Central banks will not be generating order flows that are used to hedge options positions but there is a good deal of data that should central banks tend to place orders near large round numbers and psychological figures. This type of order flow activity can contribute to increased volatility in these price areas.

 

Conclusion: Order Flow Activity Can Contribute Heavily to Overall Market Volatility

 

With all of these factors in mind, it should be understood that order flow activity can contribute heavily to market volatility at certain price levels. Technical traders tend to avoid market reports that deal with this type of activity on the assumption that all of the information needed is already contained in the charts themselves. But when we understand where order flow activity is likely to increase we are better able to structure technical positions in ways that reduce risk in the event of surprising changes in the underlying volatility. This can be critical in protecting a trading account against the prospect of margin calls if positions are overleveraged and the market starts to move sharply in the wrong direction.