To define order flow trading you need to first define what type of trading you are trying to do. Most speculators, especially in the retail forex market are attempting to place directional trades. Directional trades meaning that you are going long or short, betting that prices will either move up or down. Therefore if you believe a currency pair will go up, you execute a buy order. If you believe a currency pair will fall, you can sell it, aka “going short.” This type of trading is called directional trading. It is one of the most common forms of trading, that usually many people in the investment world, hedge fund world, and retail speculators engage in.
Now that you know you want to engage in directional trading, let us define what order flow is. Order flow is another term used in place of transaction flow. Order flow or transaction flow occurs when someone believes the price of a security will move and then decides to execute an order(transaction) in the market. The individual may want to be aggressive and execute a market order and pay the spread. That is one potential option. The other option is for that individual to enter in a limit order or stop order specifying the order flow or transaction to be executed at a certain price (limit order) or executed after the market hits a certain price (stop loss order). Both are various kinds of order flow.
The person who executes a market order is executing a more aggressive order because they do not want to sit and wait for a limit order, that may or may not be filled. The person who enters a limit order or stop loss order is generating a more passive form of order flow. Those orders may or may not be executed, but they still help immensely in constructing the order flow puzzle.
Now that we know what directional trading is, and how order flow gets executed or entered into the market place, we can begin to discuss the process for how prices move.
In the image above I have included an example of what the market depth could look like for the eur/usd currency pair. Market depth meaning that it shows the standing limit buy orders and standing limit sell orders. Therefore in the chart above, the eur/usd is trading at 1.4190 / 1.4191 with a 1 pip spread. The best bid is at 1.4190 and it is showing 10 million worth of buy orders. The best offer is at 1.4191 with 25 million worth of sell orders. The price is stuck at 1.4190 / 91. The price is not going to move unless either one of two things happens:
1. A market participant or group of market participants issues a market order to sell 10 million euros and consumes the 10 million dollars worth of standing buy limit orders at 1.4190. In such a situation the price of eur/usd would move down from 1.4190/91 to 1.4189/91, assuming the best offer stays at 1.4191.
2. A market participant or group of market participants issues a market buy order to buy 25 million euros and consumes the 25 million dollars worth of standing sell limit orders at 1.4191. In such a situation the price of eur/usd would move up to 1.4190/92, assuming the best bid stays at 1.4190.
Now that is just an example and the liquidity numbers and situation can be very different depending on the time of day and currency pair. But that is the process by which price moves. A market participant or group of market participants need to execute enough market orders in sufficient size to consume the liquidity of the best bid and offer at that time. This is what occurs every time you see price move on your chart. People in the market are issuing orders, or a series of orders, and thus generate flow – order flow. This series of orders and transactions assuming it is sufficient enough to overcome the best bid or offers is what moves the price.
Price does not move because of some magical technical indicator on your screen, or moving average combination. In order for price to move, market participants need to execute orders- enough orders to consume the liquidity at the best bid/offer. If no orders are going to be executed, then price is not going to move. That is the hard truth in trading. If your analysis does not actually result in the needed order flow, in the needed transaction flow to move then the market, then the market is not going to move in your direction. Successful traders are successful because they know that the outcome of their trade will be determined by the behavior of other traders, by the actual transaction and order flow generated by other traders.
Now we can finally get the definition of order flow trading.
Order Flow Trading is all about predicting the future order flow that will be generated and positioning yourself to take advantage of that order flow which will move the market. It is about analyzing all the different variables, scenarios, emotions, market players and positioning, expectations, etc that can generate sufficient order flow to move the price.
Let me tell you what order flow trading is NOT. Order Flow Trading is NOT technical analysis or fundamental analysis, although both of those certainly do play a part in order flow analysis. Why isn’t order flow trading technical or fundamental analysis? Because technical and fundamental analysis DO NOT always move the market. They do not always move the market because they do not always generate the necessary order flow to move the market. Sometimes they can move the market, and other times they cannot. Technical and fundamental analysis are NOT the foundation of every market. Order flow and liquidity is the foundation of every market.
Many people have experienced losing traders using both technical and fundamental analysis on various occasions. Why do those losses occur? They occur because during that particular trade your technical or fundamental (or both) analysis did not generate sufficient order flow to move price in the direction of your trade. Perhaps you placed a trade with a chart pattern and it failed. Or perhaps you placed a trade using fundamental analysis, but your stop loss was triggered before your fundamental analysis “kicked in” to move the market in your favor.
Order Flow trading seeks to correct the deficiencies in both technical and fundamental analysis – in order to come up with high probability trading based on the very foundations of every market – order flow and liquidity. It is the very best, and most profitable way to trade as long as you are willing to learn the art of order flow trading.