Someone asked me a question and wanted to know how I define the terms order flow, liquidity, and inefficiency.
I define order flow as being transaction flow. You want orders to be entered and executed. This can come in the form of a market order hitting standing limit orders. Or it can come in the form of a limit order hitting the best limit order. You want there to be flow. Flow meaning a series of transactions that get entered into the market and executed. Or it can come in the form of one large order that needs to consume limit orders at multiple price levels. But then that is a series of transactions as well since that big order is hitting the limit orders at various price levels.
If you place a market order for $100 million, you are consuming liquidity because you are consuming the standing limit orders.
Usually order flow comes in the form of market orders. They are the aggressive orders that are typically needed to move the market.
There are other ways price can move without executed transactions or with only a small number of executed transactions.
For example if both the best limit bid and best limit offer happen to shift to another price level without transactions executed, then that can cause price to move. This usually requires a period of illiquidity and is typically related to news announcements. Although there are usually some transactions executed at various price levels even if they are small.
I define liquidity as being a whole bunch of limit orders. If you place a limit order for $50 million, 50 pips away from the market price, you are adding liquidity. The best liquidity has a large amount of limit orders in terms of size, and they are spaced out in the minimum fluctuations from each other.
For example if there is $100 million in limit orders available in the EUR/USD at the best bid/offer and then another $100 million spaced away in 1 pip increments, then that is a highly liquid market.
There has to be a whole bunch of standing limit orders in order for them to consume liquidity. Because if a huge market order comes in and wants to get executed, it needs to find limit order liquidity.
When spreads are tight, it could signal a liquid market. But it is also possible for there to be tight spreads, with the best bid/offer and subsequent limit orders being small in size. It is entirely possible for spreads of EUR/USD to be 1 pip, but there to only be $10 million in liquidity per pip.
See my article on what makes a currency pair liquid.
The best liquidity is when the market has tight spreads and has a large amount in limit orders available at each pip.
There are all sorts of inefficiencies in the markets. There are arbitrage opportunities, stop loss inefficiencies, etc.
The inefficiencies that I like to trade are the big market moves. The bigger the market move, the bigger the inefficiency in my mind.
Big Market Moves = Inefficiencies
Also bear in mind that you can have a big market move during both liquid and illiquid environments.
It is entirely possible for the market to move 300 pips and consume massive limit orders in order for prices to move. It can also both do it fast or slow as long as there orders willing to consume the big limit orders.
There can also be a large market move occur when it is an illiquid environment, where the limit orders are small.
You can take advantage of both of them. The big market moves that occur when big limit orders are consumed tend to be the most durable. They tend to be the most durable because they usually have the news/sentiment/fundamental/macro forces on their side. Which can mean that the big move can result in even more sustained momentum.
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