A key to successful trading is the ability to deduce future price movements by finding situations where the orders of other people will move the market in your favor after you enter a trade. There are many ways to skin a cat. All methods are valid as long as they have an edge and work for the individual trader, so let’s delve into how to break apart the order flow information-gathering process.
How to use order flow: Where our focus should be
To be frank, I believe the objective of all known trading methods is to get into the minds of market participants and deduce how they are going to act at some point in the future, then trading to profit from it. It is just that people using the different methods lose sight of the objective, focusing on all the other minutiae instead. It’s sort of like focusing on the shadows of an object to understand object itself, but becoming mesmerized by the shadows and obsessed with them, forgetting your original intent was the object.
The most popular approaches to trading in recent years revolve around information in the charts, namely technical analysis, tape reading and price action trading. It is no surprise that they are popular given the ease of learning and somewhat mechanical applications.
But, given that we are living in an information age, it seems pretty wasteful if traders are not making use of information available outside of the charts (I shall refer this as outside information from this point on) to improve on their own performance.
There are many ways to use outside information to get what you need. One of them is to figure out the themes and events that are on the minds of market participants. Below are three essential foundations to do that while avoiding information overload:
It is impossible for most humans to properly process all the information that is available out there. Thus, it is part of human nature to make use of heuristics in decision making (“rule of thumb”).
The idea of Schelling points in game theory (simply put, something that can act as a focal point for market participants).
The market is forward looking. That is, it will seek to price in expectations of events before they happen by using existing information.
The application of the first point is that no matter how complex an analysis a market participant makes to determine how they are going to trade, it will eventually be simplified into some sort of theme or story with only a small handful of overall outcomes, e.g., risk on/risk off.
The application of the second point is that the majority of market participants will, almost as if coordinating together, focus their trading into one or a few market themes or stories at any given time which will dictate price movement.
Putting the ideas together
Our first order of business is finding the major market themes and stories. That is quite easily done by reading the various market reports or major news sources out there. If you’re straining or analyzing hard, stop. The harder you make it, the less likely you are to pick it up correctly. The more obvious it is, the better.
Unfortunately, after figuring out the major market themes and stories, a common mistake most people make is to go on and form their own opinions on the dominant themes/stories and thus how prices should move (in their own opinion). Then after a few occasions when prices do not go the way they think it should move, they will go on to conclude that outside information is not useful. Never forget you’re playing the other market participants’ perceptions, not the events themselves.
With that out of the way, figure out how the prices across various assets should behave given certain outcomes of a theme/story. This done by understanding basic economics inasmuch as how major players think of basic economics (e.g., how inflation influences central bank interest rate policy)—again, the newswire, banks/funds analysts, and the central banks themselves will mention the things that are important.
Finally, watch the price in those various assets react (or not) to certain events and data releases. Relate the price reactions to the likely emotions of other players. Did you get shocked that price didn’t move higher on a really strong Manufacturing PMI (what should have been an obvious, no-brainer move)? Others are probably shocked as well. Is it probable that others were confused as to why price shot lower even though the central bank didn’t say anything new? These are the questions you need to ask yourself. When you find that things line up just right, you can rest assured that this is a major part of the current market theme.
All that is left for the trader is simple execution using the information together with the that available in the charts.
Here are two ways to approach it:
Pattern based trading:
- Find out the direction of the market given the current dominant theme/story
- Trade the formation of certain technical patterns in line with the dominant theme/story
- Example: price direction is down, trade the top of the second shoulder of a Head and Shoulder as it is forming, aiming for an extension past the neckline.
Event based trading:
- Find future data releases/events that the market is focused on
- Determine the expectation
- Be ready to take the trade when the result is distinctly unexpected. A straightforward example is a cut in interest rate when the expectation is to hold.
Used well, information outside of the chart increases your trading edge by acting as a filter to sieve out good trading opportunities and avoid the bad ones. It does this by improving the context in which you make a decision. Good data is not always good for assets and things won’t (and often don’t) behave as they should according to textbooks. The advantage outside information has over others (when used correctly) is to provide the ability to grasp the proper directional bias, as well as the awareness of when it’s starting to change.