Discretionary Trading: Reading Order Flow

[Future]

In response to an interesting debate over discretionary vs automated trading, I wanted to expand on some of the skills required for a trader to become a successful discretionary trader.

I think by far the best discretionary traders are floor traders. One of their most significant edge is the ability to read order flow and understand trader psychology. That being said, one of the most effective skill to possess in discretionary intraday trading is reading order flow. With a strong ability to read order flow, see trader psych and emotions in price charts, and the ability to understand the type of market... indicators are absolutely unnecessary. By order flow I mean the ability to read tape, level 2, and volume.

I wanted to focus this thread specifically on order flow. First lets discuss the level 2. Level 2 can be manipulative. However, one of the biggest clues level 2 shows in my opinion is the ability to see a heavy buyer or seller. Often you will see a thin ask but price unable to lift. Then when checking tape, you will see that alot of contracts traded at that price. This is short term resistance. What you are seeing is seller with a heavy line of contracts to sell and will not step off the ask.

A couple of games you might see: tape shows huge line of contracts trade at a specific price level (lets call this level X for now). On level 2, price appears to have enough momentum and volume to take out level X. However, someone is standing firm there not showing his hand entirely and even when price breaks that level X by one tick, you can see contracts getting dumped taking price back below X. What is this indicating?

First, lets say you are an insitution with 10,000 contracts you need to sell. Are you going to dump this at the market and cause an artificial selloff? No. You can get a much better entry by distributing throughout the day whether it be the entire morning session or in the afternoon. If youre sitting on an order from several hedge funds to short 10,000 contracts in total... you want to short into the rallies. So what you are going to do is to hold the ask at a desired level. You might even by a few contracts to support any decline... but you are going to be distributing alot more contracts than the fake support you are creating. So some games you can play is:

1. Hold the ask and then withdraw the ask causing an impression that the selling is over.
2. Instead of posting a monster 5,000 lot size at the ask, post 50. When buyers start buying at the ask, start dumping without exposing your hand on level 2. (obviously this is visible on tape)
3. Withdraw the ask and then buy 500-1000 lot just to bring price up by a few ticks. This fuels momentum as traders think resistance is over. Then dump another 2000-3000 to take price back to the breakout point.

Understanding order flow offers the ability to enter trades early. Do you see strong order flow coming in that has the potential to take out the high? Does it show that the pullback is likely to hold? Are you sensing a breakout from a consolidation with the sudden buying/selling interest you see on tape? Did the level 2 bid/ask just get thicker? Thinner? What do all these information mean?

In discretionary trading understanding this type of action and actually seeing it real-time offers a tremendous edge. However, this is just one skill set and there are many other skills I think is absolutely necessary in being a successful discretionary trader. Volume, tape, price action, trader psych are just some of it.

For traders, I have a question. When you look at a candlestick chart, what do you see? Are you able to see human emotion and trader psychology in price action? If the answer is no... youll need to gain more experience and practice. For those that are struggling with trading, once you are able to see the psychology behind each price bar, you will realize that trading is about people and taking money from their mistakes. It has nothing to do with numbers, indicators, and news. How traders react to news is far more important than whether the news was good or bad. You dont need to be the first one to act... all you have to do is determine which side is going to win and just hop on board. (at an early point)

Happy trading

[torero]

Excellent post! I thoroughly enjoyed it despite it being short. I recently started to view the Level 2 and T&S together and it made a better understanding of the order flow. I do concur there are lots of mind games, pulling contracts in and out. I usually keep an eye on those that remain, say, if a level is at 50 contracts, then flicker to 100, then pulled back to 50, and so forth. I would take 50 as a real resistance, unless the T&S start showing more contracts traded at that level than 50, then I have to view this a possibly stronger resistance level. If I see momentum going down but there are at least 3-4 levels of large open orders, it doesn't bother me, unless the tape start slowing down or go fast with contracts flying by but not moving down. One piece I look for is watching for the T&S turning red to green (or green to red for upward momentum, it's a TS and personal thing of mine), showing orders being pulled off the flow.

I usually take a more careful look at natural support/resistance areas, such as opening price, day's high and low. Interesting combo of info to get an idea if prices will pierce or reverse. It's probably the most difficult thing to decipher.

My question is how does one incorporate volume at price or Market Profile fit into this order flow/tape reading skills? I know that MP is used alot and makes sense since volume is very important. The biggest contribution is the use of initial balance where locals set the pace, and after IB, it's the papers. Any input on this?

[Future]

Thank you Torero. I wanted to add a few things.... bids and asks getting withdrawn are not always traders playing games. This can easily be due to uncertainty, fear, or nervousness regardless of whether the person was a private or insitutional trader. How many times have we placed a limit order just to withdraw at the last minute due to uncertainty?

Regarding market profile and order flow, I personally do not have a tight correlation between the two. Market profile is more of an understanding of auction theory to me instead of a rigid trading methodology. For example, this is how I would use MP in my trading. Lets say prices break the previous day low swiftly on stop runs and momentum shorts. However, order flow slows and the tape surprisingly shows diminishing sellers. All of a sudden a burst of buy orders, short covering, and momentum longs enter the market and the order flow is twice as fast on this move up compared to the move down. As a matter of fact, the tape shows a burst of buying emotion with order flow showing most contracts being traded at the ask. You ask yourself... okay, if we break into the previous day range I am going long for a possible rotation back into the previous day POC or VAH. Why? Because this tail it left below the previous day low is rejection and value must be higher. (market profile concept) So I wouldnt even hesitate and throw in a market buy order once price breaks into the previous day range again.

I think specific setups are nice to catch and wait for because they line up perfectly with the tools traders use whether they be support and resistance, internals, indicators, etc... However, understanding order flow allows one to enter based on momentum and gut instinct. (important you realize u have a solid instinct and not impulse)

Lets say prices decline to test the low of day. I am observing tape and level 2 to determine whether to fade this move or play a breakdown. I see temporary support with buyers trying to keep prices up. However, tape and level 2 shows a thick ask as prices move up by a few ticks. In other words, sellers are still trying to dump contracts. Order flow tells me this is weak and that we are likely to break the low. Hence, I would short at 1-3 ticks above the previous day low. For new traders, you might wonder why in the world would you do that? I am comparing the action on level 2 and tape on the leg up vs leg down. (the leg can be anywhere from 3-10ticks)

Happy Trading.

[BlowFish]

Another xxcellent thread. Thanks Future.

This is a subject dear to my heart. I think determining potential areas of S/R (which to be honest is trivial) and then monitoring order flow at these levels to see if they are actually being respected is as close to the golden goose as you can get.

Of course if you can monitor order flow with good proficiency these potential areas need not be determined in advance as the order flow will tell you anyway.

Looking forward to seeing where this goes. May the flow be with you.