[Essay] Market Depth & Order Flow

[hanz 10]

I have some free time right now so I thought I’d submit and entry on some aspect of trading that most people pay no attention to yet can play a very big part in your trading success.

 

What I want to talk about is what a lot of traders call reading “order flow” or just “the tape”. I think a lot of people spend a lot of time working with indicators for their charts and don’t even think to just watch the orders moving in and out of the market as well as the trades that tick off (also called “prints” in the biz).

 

Most quote providers offer market depth on electronic trading these days and I highly recommend utilizing this gift. The edge that floor traders have is now being given to everyone in the marketplace who trades these instruments, thus providing complete transparency and an even playing field. The problem is that if you’re not a professional and aware of what this actually means, you cannot capitalize on it.

 

The next trading day, load up the market depth window of your favorite electronic mini contract and just start observing what you see. I’m going to be honest with you. This is going to be one of the hardest ideas you will ever try to comprehend as a trader. By watching this screen and this screen alone, you can gauge trader sentiment, their emotions and really make out what exactly is going on out there, things your indicators will never say.

 

The first thing that is apparent is that the market moves like a pendulum, swinging one way and the other. It can look very messy at times but it is always essentially doing the same thing. It makes a move, a counter move, a counter move to that, etc, until it finds equilibrium and then it does it all over again. Watch how it does this over and over again and you will start to really get a feel with how the market is moving, when it’s turning the other way, where the pressure really is, etc.

 

One thing to look for is what is happening in pullbacks. Let’s say the trend is up. The market has been making higher highs and lower lows and we’re in a mini down cycle and price is pulling back. The first thing to observe is how is the market pulling back? Is it a frantic sell-off pullback where the longs are scrambling? Is it orderly and more of a “drift” down?

 

A frantic sell-off usually means the longs have panicked. This is fear in its purest form. They’re jumping on top of each other to sell. Offers are coming in and they’re hitting bids. The down thrust stops for a little bit but there is no mini bounce in the action. After a tiny stall they are hitting bids again, even if there aren’t many offers. They just want to get out, and they want out NOW. The lack of bids and support is a bad sign if you’re looking to purchase this pullback. If going long is the correct play, there needs to be buyers somewhere to hold the price up.

 

An orderly pullback is more along the speed of what we’re looking for in terms of wanting to get long. Sellers are taking profits but it’s a slower move down. Sellers do push it down, and it can look rather thrusting when it happens, but you then see buyers step in and gobble up some levels and back off. Sellers may come in again, push it down, but then again, buyers come in and gobble up a few levels and back off again. This is the big money buying a pullback. You’ll see 6 times more contracts on the offer but the bid is holding because someone is showing a 10 lot and sitting there refreshing it. They’ll print off 50-100 and step off the bid allowing the price to come down more. Now, when I’m using number examples, understand this is all relative to the instrument you’re trading. Printing 50 and backing off isn’t as significant in the ES as it is to the YM, but the idea is the same. Eventually the sellers are going to be done and the selling will become exhausted at or very near a support level that you’ve been watching for it to pull back to. Buyers will start stepping in and when they gobble up some contracts, the selling that follows isn’t as strong any more. The point here is that buyers were sucking the stuff in the whole time it was pulling back and that’s the difference. A big money player, like a huge bank or fund, is working thousands of contracts and you’re going to notice it. I don’t care who you are. An elephant can’t run through a cornfield without leaving tracks.

 

On a downtrend, typically what happens is the selling is frantic and the bounces are slow. Same type of scenario except that moves up in the previous scenario tend to be slow also. This is just a psychological thing. Bull trends tend to be slow, bear moves tend to be very, very fast. If the moves up are fast, it’s most likely short scrambling. Fast moves tend to indicate fear; people not in their right mind. I believe Alan Greenspan dubbed this situation “irrational exuberance”.

 

Honestly I could write a book about the market depth screen alone. A lot of it is something that cannot be quantified. I spent years scalping NASDAQ Level II without ever using a chart, just using order flow, momentum and levels and I can say that the same thing applies to the futures market. If you wanted to, you could do this just to scalp, and I mean REALLY scalp; taking 3-4 ticks in a matter of seconds. If that suits your personality so be it. I did that for years and did very well. It’s how floor locals make their money and there are many people doing it on mini futures now. In my opinion, however, it’s just too killer on the nerves.

 

The point of this little essay is to give you some perspective into thinking like a local trader. If you’re like me, you’re looking at long term charts, medium term charts and short term charts. However, most people are not watching the flow. Work at adding this aspect to your trading to become a local when you’re looking to execute your trades. It will help you get great fills. Think how much money saving 1 tick per execution would save you. 1 tick on the YM is $5 and figure 3 trades per day. That’s 6 filled orders. 6 ticks = $30 per contract traded. 20 days a month trading is $600 per contract. That’s reason enough isn’t it? Now throw in the fact that adding this technique with solid technical analysis will make you a solid, well-rounded trader, which should be everyone’s goal.

 

See, you want to become a local trader when you need to be and be more in tune with the market you’re trading. By watching the order flow and characteristics of the bids, offers and prints, you can be so much more effective. Don’t spend your time staring at your chart to get the last trade. Watch your market depth. You’ll thank me for it.

 

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http://balancetrader.com/

[tc6020 10]

Thank you so very much! Would you share more to us here? thanks again.