Understanding the Basics of Order Flow

Order flow analysis is an additional tool in the toolbox of traders, offering insights into the strength or weakness of buying and selling pressure. At its core, order flow revolves around the interaction between buyers and sellers. If we can understand who is the aggressor or who is more passive we can better understand price movements and market sentiment. Let’s break it down and make orderflow more approachable for all traders.

The Bid and Ask

At any given moment, there are two primary prices in the market: the bid price and the ask price. The bid represents the highest price a buyer is willing to pay for an asset, while the ask represents the lowest price a seller is willing to sell an asset. The difference between the bid and ask prices is known as the spread, which reflects the liquidity and competitiveness of the market.

Aggressive Buyers and Sellers

Aggressive buyers and sellers are characterized by their willingness to transact at the prevailing market prices without waiting for better opportunities. Aggressive buyers place market orders to buy immediately, lifting the ask price. This means that if all of the sellers asks are filled, price needs to increase to the next available (passive) seller. On the opposite side, aggressive sellers execute market orders to sell, pushing down the bid price. Once all bids are filled, if aggressive sellers are still “hitting the bid” price needs to move lower to the next available (passive) buyer.

In simple terms, aggressive buyers want to get filled, and they want to get filled now, it doesn’t matter if the next available price is higher. The opposite is true for aggressive sellers. They don’t care about the price, they care about the timing. The take away from this sentiment is that a strong trend may be developing.

Passive Buyers and Sellers

In contrast, passive buyers and sellers are more patient in their approach, placing limit orders at specific price levels away from the current market price. Passive buyers set limit orders below the current market price, hoping to buy at a discount, while passive sellers place limit orders above the market price, aiming to sell at a premium. Their presence adds depth to the order book, shaping the supply and demand dynamics in the market.

Passive participants don’t necessarily indicate a strong trend from a continuation perspective, but rather from a resilience perspective. If there are large chunks of passive orders waiting to get filled, those participants can act as blockers. In the case of an uptrend, if there is a large limit buy block below, that could result in a higher low. In the case of a downtrend, if a large limit sell block is above, that could produce a lower high.

Level 2 Quotes and Time and Sales

Level 2 provides a detailed view of the order book, showing the current bid and ask prices along with the number of shares available at each level. This depth of market insight allows you to gauge the strength of support and resistance levels and anticipate potential price movements. Time and Sales, on the other hand, provides a chronological record of all trades executed for a particular asset, including the price, volume, and timestamp. Usually if the order is green it was a buy on the ask, and if the order is red, it sell at the bid. By analyzing Level 2 and Time and Sales data together, you can determine if larger trade size is being filled on the ask and it continues to get lifted (aggressive buyers), or if larger trade size is being filled on the bid (aggressive sellers).

Depth of Market (DOM)

The Depth of Market (DOM) shows pending buy and sell orders at various price levels in the order book. Simply a way of seeing where resting limit orders are. It can help show where buyers and sellers might step in to provide resistance. Generally we use this as a confluence tool and have more confidence if the DOM aligns with a technical level. When we get to the zone of interest then we think about what the L2 and T&S show as a reaction.

Footprint Charts

Footprint charts, also known as volume profile charts, provide a visual representation of trading activity at each price level over a specified time period. Each footprint on the chart corresponds to the volume traded at a particular price, offering insights into where buyers and sellers are active and where significant trading occurred. Footprint charts help traders identify key support and resistance levels, as well as potential areas of imbalance in the market.

In the context of footprint charts, an imbalance occurs when there is a significant disparity between buying and selling activity at a particular price level. Some traders opt to show their footprint charts strictly as imbalance charts. In this case you would set a threshold of what constitutes a substantial volume imbalance, not price imbalance, and only plot volume that is above that threshold. Anything below could be seen as normal market conditions, and not suggest substantial insights for trend change or continuation.

Conclusion

Order flow analysis gives traders a better idea of specifically “who” is participating in markets. By watching the level two and time and sales, we can determine if the buyers or sellers are aggressive, and thus who the passive side of the trade is. When looking to trade a specific level, this helps build confidence in trading a reversal or continuation at a specific point. The depth of market, or footprint charts are two great tools that show us volume at price, and a deeper understanding of the types of participants at a level. Pair this with the basics of technical analysis, and your strategy will become even more robust.