Some people consider order flow and liquidity to be the same thing. Now there are some similarities. But the differences are even more pronounced. Deep thinking about the differences between order flow and liquidity can help you develop the order flow mindset, find the inefficiencies and take advantage of them. Asking the best trading questions to yourself and others always helps.
Some people may get order flow correct, but they get liquidity wrong. This usually happens with big hedge funds instead of retail forex traders, but it can be very advantageous to think about the market from the view of a big player.
What is order flow? It can be passive order flow in the form of limit orders, or aggressive order flow in the form of market orders and stop loss orders. Both can be useful. The aggressive order flow is more useful and leads to bigger profits, because it causes huge market movements. But even the aggressive order flow needs to consume some form of limit orders. They just consume the limit orders at progressively higher or lower prices, thus moving the price.
The aggressive order flow is more useful, because you need some form of volatility to make money. If you want to make the most money, you need to embrace the volatility. If the market is stuck in a 30 pip range for the whole day, there isn’t that much money to profit from it. Sure you can try to play the ranges, a few stop hunts, maybe an option barrier. But the biggest and fastest money is made in the big market movements.
Passive order flow in the form of limit orders can be very interesting. Because lets say there is a huge order that needs to be filled and the market participants are choosing to fill that order using limit orders. They can be in the form of option barrier protection, large take profit orders, macro bids/offers, even central bank intervention of the type that the Swiss National Bank engaged in last year.
The passive order flow can be important, because it represents a potential support and resistance area that may be difficult to crack. They can also be very interesting because there are times when that passive order flow can be market participant that is a willing sucker and is just providing liquidity to the aggressive traders who are executing market orders against their limit orders because they know some big move is going to happen.
You need order flow, aggressive order flow to be transacted in order for price to move. That means that the order flow needs to consume the liquidity at the various price points before moving to a new price point. Once that happens, your trade can get into the profit.
But is not a “real profit” yet. It is just on paper.
It is a paper profit. It is an unrealized profit.
In order for the paper profit to be converting into a realized profit, there has to be liquidity available when you go to close your trade. If you execute a market order to close your trade, you are relying on the passive liquidity of the limit orders in order to convert your unrealized profit into a realized profit. Were those limit orders not available, then you would not be able to convert your paper profit into realized profits.
Alternatively you can choose to exit the trade using take profit limit orders. Then you would rely on other aggressive market orders to come and hit your limit orders, which may or may not happen.
Order flow to push your trade into profit is great. Liquidity to exit your trades at the price and time that you want is even better. They are great on their own. But together, order flow and liquidity will make you a lot more money.
Now retail forex trader don’t really think about liquidity that much because they are placing small orders. Orders of 10,000 units, 100,000 units, or 1 million units is not going to move the market. They are not going to have liquidity problems during most of the market conditions, so they don’t think about it.
The big hedge fund traders have to constantly think about not just order flow to push their trade into profit, but whether liquidity will be available to exit out of big positions. Because there are many times when the markets turn illiquid. There have been plenty of occasions in foreign exchange history where spreads on USD/JPY have surged to be 100-200 pips wide for extended periods of time.
Retail Forex Traders vs Hedge Fund Mindset
For example if you have a long position in USD/JPY and aggressive order flow pushed prices 100 pips higher. You have 100 pips of paper profit. Great you say? But what if extraordinary market conditions result in the spreads widening to 50 or 100 pips. If you want to to convert your paper profit into unrealized profit, you need to accept the prices offered by the market during that time. Now, a small $1 million order may get executed no problem.
But what if a hedge fund had the same trade on, but with a $1 billion dollar position? They had the same 100 pip paper profit as the retail forex trader, but liquidating such a position will push the price against them, especially when the market spreads blow out and there isn’t much liquidity.
There are also other occasions where investors or traders are dealing with illiquid assets that do not trade often. They may buy an illiquid asset. There may be bullish transaction (order) flow to push the price higher. They mark the assets value by the last trade deal price. It shows a large paper profit. Only problem is they are unsure what price they will get if they go to sell the asset, because the market is illiquid and hasn’t traded in several days or weeks.
There was bullish order flow to cause a paper profit, but will there be liquidity to exit the trade and have a realized profit? Such are the questions when trading in bigger size and with more illiquid assets forces you to ask.
Order Flow Conclusion
One of the reasons why retail forex traders fail is because they don’t think about markets in terms of order flow and liquidity. They don’t think in terms of order flow because they may be stuck in the technical indicator or chart pattern world.
They don’t think about liquidity and how big players deal with that problem because they are only executing small orders. The average retail forex trader thinks that there is unlimited liquidity at every price.
When in reality the fast track to trading progress and profits involves thinking how the big players deal and react to these problems.
That was a small sample of what the content in the Hedge Fund Mindset Mastery bonus portion to the Order Flow Mastery course will be about.