Order Flow Trading

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What is Order Flow Trading?

Many wonder what order flow trading is and how it can benefit them RIGHT NOW. The answer is simple! Order Flow Trading, like all trading, represents an exchange of value. In this particular case the value trade includes customer order activity. Unlike Technical and Fundamental Analysis, which try to use historical activity analysis techniques to predict where the market will go next, Order Flow Trading is a discipline focused on the actual orders placed.

To appreciate the answer you must first ask a different question:

Why Do So Many Traders Fail?

Trading is a rather unique enterprise. It would seem that it is the only career where the people least likely to become successful at it are willing to risk huge portions of their net worth for the right to apply. Yet, year after year, the same kind of people jump into the market hoping to make it big; never realizing that the chips are stacked against them.

Research suggests that aspiring traders near universally share three defining characteristics:

The problem is not really the possession of these attributes so much as it is the way these attributes influence an aspiring trader’s career path. You see introverted / analytical types are all about research. Before they can go about doing something, they need to research the best way to do it. This is usually a wise course of action, but in the case of financial market trading the research leads to an inappropriate conclusion that in order to achieve trading profits, traders must engage in either Fundamental or Technical Analysis. It is inappropriate because, in practice, those disciplines rarely lead to the profits traders are seeking.

This does not mean aspiring traders cannot earn profits. They most definitely can. The point is that in doing what seems like the right thing, most traders set themselves up for failure because the research they do gives them a flawed understanding of the profit making process.

To understand why, we need to look at the two disciplines in some detail.

Fundamental Analysis

Fundamental analysis is a method of evaluating an asset that entails attempting to measure its true value by examining related economic, financial, and other qualitative and quantitative factors.

Fundamental Analysts are practitioners who attempt to study everything that can affect the value of a security, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). The end goal of performing fundamental analysis is to produce a measure of true value that an investor can compare with the security's current price. The point of that goal is to figure out what sort of position the analyst should take within that security (underpriced = buy, overpriced = sell or short). The implication is that if an aspiring trader can accurately analyze when a security is trading at a price divorced from its true value, they will be able to enter a position and collect any discrepancy through arbitrage.

Once an aspiring trader understands this, the suggested next step is to set off on a quest to discover the aforementioned arbitrage opportunities.

Unfortunately, even if they are successful in determining true value - which the research often fails to mention is only theoretically possible - they are unlikely to turn a mispricing opportunity into a profit. To earn a profit from an arbitrage opportunity, a trader not only needs to know price and true value, as they exist today, they also need to predict the price and true value that will exist in the future. This is because neither true value nor price is a fixed variable. Even were price and true value to be divergent today, it will take some measure of time for both values to come together. In the interim, true value may change meaningfully against the trader’s position and/or price can become even more divergent.

One could argue that if a trader possessed the where-with-all to accurately assess true value in the present, they would possess an equally likely ability to do so with future value. There may be some merit to this argument. However, even if we were to accept the argument at face value, the same cannot be said about price because price is more a reflection of the thoughts, fears, and behaviors of the traders participating in the market at that moment in time. So ultimately, determining price in the future requires the prediction of other trader’s behaviors.

Once we start talking about predicting the future behavior of traders, we move away from the clean world of numbers and math, where the introverted / analytical type can excel, and descend into the messy realm of psychology, human nature, and emotional response.

It is at this point, where we begin to realize how the chips are stacked against the average aspiring trader. The problem is that in order for someone to understand what other people are likely to do, they must have a deep understanding of how people think and feel. The sad reality is that traders usually have introverted personalities, and this often precludes them from having the necessary people skills to make the requisite predictions. Without that prediction, no profits can be made and, ultimately, the aspiring trader will fail to reach the intended objective.

Instead of facing reality and doing what needs to be done, many traders dive into the world of technical analysis.

Technical Analysis

Technical analysis, by comparison, offers up a neatly organized (and very seductive) solution for overcoming the people problem. However, the complexity involved in the practical application of that solution has afforded very few traders an opportunity to achieve the desired outcome.

At its core, technical analysis assumes that a securities market price reflects all relevant information. By defining “information” broadly, the theory of technical analysis suggests that a securities price chart not only includes all the known fundamental data, but that of the hopes, fears, thoughts, and idiosyncratic behaviors of market participants as well.

A closely related hypothesis is that, because investors collectively tend toward patterned behavior, price activity tends to repeat itself over time. Therefore, by searching out repeating patterns in historical price activity, a Technical Analyst can profit from its recurrence in the future.

This is an extremely seductive theory for introverted / analytical types because it not only eliminates the need for understand economics and the mechanics of financial analysis, it promises to eliminate the need to understand people as well.

Of course, while that sounds great in theory, it fails to account for the sheer volume of potential patterns and data points that the financial markets produce. Not only are there thousands of different securities, each security produces dozens of different charts. Each of those charts can be broken up into an infinite number of data point sequences, and each of those sequences can produce a seemingly never-ending supply of indicators and other derivative calculations.

All told, financial markets produce more potential price patterns in a single day then the most powerful supercomputers can analyse in a year. Without the benefit of such machines, Technical Analysis becomes an endless exercise in searching for needles within haystacks.

For those who enjoy such enterprise there is a small chance to turn all that searching into a lucrative trading career. However, the wiser path is to attack the problem in a slightly different way.

Interestingly enough, despite the enormous obstacles in the path of replicable pattern discovery, traders throughout history have managed to discover a few seemingly meritable examples. It is not clear why these patterns were shared with the larger technical community, but now that they have been, many traders can (and do) avoid the haystack problem through the simple expediency of trading previously discovered patterns.

Unfortunately, in doing so we inevitably ran into the problem that Technical Analysis sought to avoid at its outset. You see, regardless of the original merit, there have been numerous empirical studies conducted on these technical patterns and in every case, the conclusion was that the pattern itself did not produce predictable outcomes to any statistically meaningful degree.

How does this jive with the claims of numerous traders that they are using these patterns to earn profits? Well, if we assume that the claims are credible, the only conclusion we can make is that they are using some additional analysis techniques to improve the probabilities.

While there is little empirical evidence regarding exactly what those techniques are, anecdotal evidence suggests that individuals who use the common patterns profitably combine them with an examination of the broader fundamental factors influencing the behavior of market participants.

This is ultimatley the reason why most aspiring trader consistently fail to achieve success in this business. For the introverted / analytical types, analyzing and predicting the behavior of market participants does not come easy. Nevertheless, the research they do suggests that they need to engage in Technical or Fundamental Analysis if they have any hope of success. Unfortunately, in order to turn either Technical or Fundamental Analysis into a profitable trading career, the analyst needs to analyze and predict the behavior of market participants. It is one of those Catch 22 situations and, for most traders, it is often easier to give up on the endeavor then discover a viable solution to the problem.

Order Flow Trading is a Strategy for Predicting the Future

For all the fuss made, predicting the future isn’t nearly as hard as it may seem. The market is driven by the expectations, aspirations, and fears of the people who participant in them. All of this is a function of human nature and human nature is actually quite predictable once you understand humans.

The problem is that when it comes to figuring out why people do the things they do, those who are most likely to be attracted to trading can find it very difficult to determine exactly where to begin.

Order Flow Trading solves the problems of fundamental and technical analysis by focusing directly on the order flow activity. It takes some effort to master the principles but it is by far the fastest and most reliable way to trade.

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