What is Order Flow Trading - Part 2

03/06/2014 9:00 am EST

Focus: FOREX

There is a lot of confusion and dispute over what exactly order flow trading is, let alone how it can be utilized as a profitable trading method, notes Adam Lemon of DailyForex.com.

Yesterday, I began a series of articles about order flow trading. We defined order flow trading as a wide-ranging term for styles of trading that are all focused on anticipating where large buy and sell orders would be located, and in trading along in tandem with those orders. In short, order flow trading involves picking levels. I outlined how to find those likely levels: look for previous daily and weekly highs and lows, and emphasized that many of the best trades are the most frightening counter-trend trades. I will now try to explain why this is so.

Let us imagine the following hypothetical scenario. It is a few minutes before 8:00 am London time, an hour that is commonly regarded as the “London Open,” a time at which forex volatility tends to rise dramatically. Looking at the daily chart on London time, yesterday closed very near its open, and the overnight Asian session has been extremely quiet. Yesterday’s high was 1.3100 and yesterday’s low was 1.3000, the price right now is approximately 1.3050. In other words, yesterday’s daily candle was a doji, and yesterday’s high and low are both confluent with round numbers.

We reach 8:00 am London time and the price begins to rise sharply. After just half an hour, the strong upwards move has the price hovering just underneath 1.3100.

Some traders will look at this scenario and see strong buying pressure pushing the price up. However, a sharp move up may simply mean that sellers have pulled their orders back to 1.3100, creating a misleading vacuum that allows the price to rise sharply. As soon as the price hits 1.3100, order flow sellers who have picked this level as an excellent selling level step in with short orders, and the price falls dramatically, reaching a short profit of 40 pips within another half an hour, suffering a drawdown of only two pips.

What many experienced order flow traders will tell you is that the moves that fly quickly to the obvious levels worth going counter at are usually the best trades, because the quickness of the move is indicative of a vacuum rather than strength.

Of course, it goes without saying that a simple strategy of fading every previous daily or weekly high is, over time, unlikely to prove very profitable. A certain amount of discretion needs to be utilized in picking the right levels at which it is worth getting involved. Note that order flow trades do not need to be counter: you can wait for levels to be broken and retested before trading them in line with the trend.

Here are a few tips for picking pairs to trade and the levels at which there is likely stacked-up order flow:

  • Choose the most liquid pairs. At the moment the best pair for fading levels seems by far to be EUR/USD, although it does not move very far.
  • Pick levels with confluence of more than one recent previous daily high or low and trend lines, round numbers, or pivot points.
  • If the pair has already made a typical day’s range, that is a good sign.
  • If the pair reaches the level without hitting any other obvious level during the most liquid part of the day, this increases the probability that it will be a good fade trade.
  • Use tight stops, as the really good trades will usually not exceed the level by more than a few pips.
  • Look to protect or lock in some profit after the trade goes about 40 pips (with EUR/USD) in your favor.

This kind of counter trend trading is best practiced in conditions where the daily charts are consolidating and there is no obvious trend.

By Adam Lemon, Contributor, DailyForex.com

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