What is Order Flow Trading?
Order Flow Trading is a financial markets trading strategy focused on the orders that participants have, and will, enter into the order book.
To earn a profit via trading one must enter a position in advance of a price change, hold through that price change, and exit once the move is completed. Since price change is the result of participant order activity, Order Flow Traders analyze order flow in an effort to predict when and in which direction the next exploitable change in price will occur.
The Order Flow Trading label has been applied to many things. From tape reading… to microstructure analysis... to option and stop hunting... to technical pattern rationalization -- it seems that any time a trader makes a decision based on order mechanics they call it order flow trading. While one could justifiably consider any of these to be “order flow trading,” the reality is that it’s all of them and more.
At its core, Order Flow Trading is a mindset. And not just any mindset! It’s a mindset that exists one level higher in abstraction than the one most other traders in the market think on.
Okay... and uh, what does that mean exactly?
Well, what I’m talking about here is something called the metagame. In short, the metagame is the “game within a game” where players make decisions, not on the basis of an elementary strategy called for by a game’s rules, but on information that exists outside the game.
For example, in the game of chess there is a strategy of play that makes it possible to win a match in just four moves. If Player A watches Player B employ this four-move strategy five times in a row, then acts to thwart that four-move strategy before it becomes evident that Player B is employing it, Player A is “playing the metagame.”
In that example, Player A is not making his decisions based solely on the inherent value of his strategy. What he is really doing is exploiting his knowledge of the other player to gain a strategic advantage. And that’s precisely what the Order Flow Trading discipline attempts to do within the game of financial market speculation.
Of course, the way order flow traders do it is a great deal more complex because the speculation game is so much more complicated. Where chess has two players, a finite game board, and a discrete beginning and end to each game, financial markets have thousands of players, an infinite range of prices, and the game is played across an open-ended time line.
However, even with all these dissimilar aspects, the thought process both metagame strategies employ requires the same three steps:
Step 1 - Learn the Rule Set
Metagaming is all about anticipating the choices of one’s opponents. However, before one can realistically anticipate those choices, they need to understand the scope of the choices available. That means understanding the rules.
In a game like chess, the rules are contained in a readily accessible rule book. That rule book defines how each game piece can move, the structure of the game board, and the time-frame within which each player is permitted to act.
The financial market corollary to this rule book is the field of Market Microstructure. Even for a game as complex as financial market speculation, the rules impose clearly defined restrictions on the strategic choices available to each player. Microstructure explores those rules and the restrictions they create. Therefore, before you can play the financial speculation metagame, you need a thorough understanding of the market microstructure.
Step 2 - Study your opponents and determine the strategies they are likely to employ
Learning the rules is an important step. But, it isn’t enough to just know what is and isn’t possible. You also have to develop an intimate understanding of the way people play the game.
At first, this might seem like a daunting task. After all, complex games like chess and financial market speculation have a near infinite variety of ways in which they can be played. However, after careful analysis it quickly becomes apparent that even though it CAN be played in an infinite variety of ways, most players tend to consistently employ a number of “elementary strategies.” Once you know those strategies, figuring out which one your opponent is likely to use becomes much easier.
An elementary strategy is one that is well understood, accepted as viable, and consistently used by serious players of the game.
The game of chess has 50 or so of these elementary strategies, including things like the Benko Gambit opening, Pins and Skewers mid-game, and the King/Rook endgame. If you know all these strategies, you can not only play a damn good game of chess, you can easily identify which strategies your opponent is using.
In the realm of financial markets, these elementary strategies come in the form of common technical and fundamental trading systems you read about on the internet. Moving average crosses, support resistance breakouts, and Fibonacci retracement strategies are a few examples of the elementary strategies of the speculation game.
Once you have familiarized yourself with these strategies, it becomes possible to anticipate how the players who prefer these strategies will act. And that gives you many strategic advantages when playing against them.
Step 3 - Adapt your own strategy to exploit the weaknesses in your opponent’s strategy
Once you know the rules, and the strategy your opponent(s) are using, the final step in the process is to exploit that information by tailoring your own strategy to take advantage of the weaknesses in theirs.
You now have a definition for Order Flow Trading. Of course having a definition for the methodology is only a tiny piece of the puzzle. Actually figuring out how it works in the real world is where the profits come from.
Unfortunately, as easy as the three steps that go into Order Flow Trading are to describe, teaching someone how to perform them within the game of financial market speculation is anything but easy. Step 1 requires you to navigate the vast and labyrinthine world of market microstructure. Step 2 requires you to analyze the thought processes of a wide array of dissimilar participants who are all operating simultaneously. Step 3 requires you to think in a way other than what you are accustomed to. In short, none of these step descriptions are enough to earn profits with. To understand how to employ the metagame mindset to financial markets – and earn Order Flow Trading profits - you need a detailed guide for navigating each step.
Ultimately, that’s what Order Flow Trading for Fun and Profit was written to do. Toward that end, I have broken this book into three distinct sections. Each one corresponds to a step in the metagame analysis process:
- In Section 1: Microstructure Analysis, we will learn about market microstructure, its rules, and the limitations those rules impose on participant strategy.
- In section 2: Reading Order Flow, I will teach you how to analyze the participants and their strategies. We will then use that analysis to construct a real-time virtual order book for a financial market security.
- Finally, in Section 3: Playing the Metagame, we will explore some of the ways in which you can exploit the order book and the strategic choices of the markets participants to earn a fabulously high income from trading.
However, before we get to the lessons that will help you learn the metagame mindset of Order Flow Trading, I feel I should warn you that this isn’t going to be an easy read. Putting aside the fact that I am a trader, not an author, and that my writing ability leaves much to be desired, the subjects we are about to cover are often highly abstract and complicated.
In other words, this is not the type of book that can be skimmed. For it to have any value for you, you will need to study hard and think deeply about the things I am going to say. If you do that I know there is enough information here for you to reach your goals. But reaching those goals is entirely dependent on you. Take your time. Take it seriously. And by the end of this book, I promise you that you will not only have an intimate understanding of Order Flow Trading, you will possess the required skills to be a profitable Order Flow Trader.
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