Order flow analysis is one technique that has made its way from traditional markets to the cryptocurrency scene.
Also known as ‘reading the tape’, order flow analysis involves predicting the direction of the market by looking at the buy and sell demand on the order book. Order flow is usually applied by scalpers to improve their entries but can also help to identify fake orders.
What is Order Flow Analysis?
Institutional and high-frequency traders are the biggest users of order flow analysis and may even ignore the price chart altogether, using just the order book to work out the demand and supply in a market. Retail traders may also use order flow analysis in a manual way (unless they are well-versed in programming).
To gain a good understanding of order flow analysis, we first need to have a good grasp of the different types of orders that can be used.
Limit orders are either below or above the current market price and ensure that a trader does not pay more than their ideal price.
Market orders are executed as soon as possible at the market price, reducing liquidity of the market. Price will only change once liquidity (limit orders) at a certain price has been exhausted. As a result, market orders are the main drivers of price action and are not revealed by a trader until it is absolutely necessary.
Stop orders are used to limit losses and are a type of limit order when the stop price is reached becomes a market order. As they provide liquidity to the market, they also contribute to price changes as liquidity is consumed when they become market orders.
Now we know the purpose and effects of different order types, let’s outline how they interact with each other to cause a change in the price.
How Orders Interact with Each Other to Move the Price
Trading can be thought of as a game where each trader is trying to figure out what other traders are doing and is an important aspect of order flow analysis.
When a trade is filled, a limit order has been matched with a market order. Buying pressure is observed when buy market orders are matched with sell limit orders, whereas selling pressure is observed when sell market orders meet buy limit orders. Therefore, in an uptrend buy market orders take liquidity off the book as they are matched with limit sell orders, until the market reaches a supply zone too strong for the buying pressure to overcome. However, in a downtrend, sell market orders consume liquidity provided by the limit buy orders beneath it until a demand zone is hit that is too large for selling pressure to overcome.
Often these large order blocks (also known as 'walls') can prevent a trend from continuing and precipitate a reversal. Therefore, traders should keep an eye out for relatively large orders in the book, sometimes it will disappear as the market approaches these orders - known as spoof orders. The purpose of spoof orders is to prevent the market price from moving beyond a particular price level.
Using the Order Book and Depth Chart
Given trading is a zero-sum game (one trader’s loss is another trader’s gain), you will want to know what other market participants are doing and adjust your strategy accordingly. One way you can keep updated on what other traders are doing is to monitor the order book. However, be aware that there potential market orders and limit orders that are not shown on the book, only the rested limit orders are shown in Interdax's book.
To get an idea of how to use order flow analysis, a screenshot of Interdax’s order book is shown below. The order book and depth chart displays the tug of war between buyers and sellers in real time.
A green arrow is shown when the last traded price goes up while a red arrow is shown when the last traded price goes down.
The inside bid and the inside ask are the best buy and sell orders, respectively, where the difference between the two is known as the spread. In the image above, the inside bid is $7,124.0 while the inside ask is $7,125.5, therefore, the spread is $1.5.
The spread also characterises the battle between buyers and sellers. If the spread is $1.5, the inside bid will have to move up by this amount to get a seller to enter a market order. Similarly, the inside ask will have to move down by $1.5 to get a buyer to enter a market order.
The order book depth above shows the depth for supply and demand in the market. The total column on the right-hand side shows the volume profile for each price point, showing how strong demand or supply is. For example, we see at $7,120 buy demand is very strong with 198,049 contracts while $7,130.5 is a strong supply zone with 202,029 contracts.
The book only displays rested limit orders but does not show market orders until a limit order is hit. Now we will look at some methods of trading incorporating order flow analysis.
One aspect of order flow analysis is stop hunting, where traders take advantage of areas with a lot of stop orders. Going back to the concept of trading as a game, retail traders tend to use support and resistance levels to inform where they place their stops. Knowing this, we can work backwards and plan our trades knowing that a mass of stop orders will be above (or below) a particular resistance (or support) level and exploit the behaviour of these market participants.
Let us look at an example.
Suppose a trader wants to go long using 100,000 contracts and the order book depth is shown below, where the current price is $7,150/$7,151. If the trader uses a market order to buy, their position will use up liquidity form three prices ($7,151, $7,152, and $7,153) with an average fill price of $7,152.25 = (0.25*7,151)+(0.25*7,152)+(0.5*7,153).
Suppose the trader thinks there are stop orders at $7,160, with at least 200,000 orders, which once filled propels the price to $7,170.
Since the trader already guessed there were 200,000 contracts in stop orders at $7,160, they can preemptively put a sell limit at $7,160 for 100,000 contracts, before entering the long position.
With an average entry of $7,152.25 and an exit price of $7,160, the trader has made $7.75 per contract and has completed what is known as a stop hunt.
An example of stop hunting is displayed by the chart for BTC-PERP below. A trader may identify two areas for orders:
- $10,662 is where the trader thinks the price will go and is aware of many stop orders around this area.
- $9,494.50 is where the trader believes he can market buy and not move the price too much, as there are sell stops they can buy into.
We see from the chart that the price moved below $9,494.50 and the trader is filled at the price they specified. Any traders that went short into the buy limit at $9,494.50 are now likely trapped and buy orders to cover their positions will provide fuel for upward momentum.
With a sell limit at $10,662, the trader is sure it will get filled because of the presence of stop orders and hence liquidity at this level.
Another aspect of order flow trading is the concept of stop cascades.
If there are enough stop orders clustered around a particular price point, they could consume enough limit orders to propel the market to the next level of stop-loss liquidity and this chain reaction is called a stop cascade.
For instance, the chart below shows that stop orders were likely built up above each of the four highs, which caused the price to spike upwards. You’ll notice that the upward move that caused a stop cascade happened quickly given the magnitude of the price move.
Using the Volume Profile in Order Flow Analysis
The Volume Profile can complement order flow analysis. Since the Volume Profile shows the volume traded at particular prices and allows us to visualise the order flow, we can use the high value nodes of the volume profile to determine where a lot of liquidity lies.
The volume profile also shows low value nodes (areas where the price will move through quickly), the point of control (a significant support/resistance/re-test level) and volume area (where 70% of all volume has been traded).
The point of control shows where the price is most likely to consolidate and is considered an important support or resistance level (and hence many stop orders may lie above/below it).
Read more about the Volume Profile here.
Tips for Order Flow Analysis
There are some general tips to keep in mind when applying order flow analysis:
- Higher timeframes dominate lower timeframes.
When applying order flow analysis, higher timeframes are more likely to provide more information. Since most traders use the daily and weekly charts, they are more likely to place stops at important supports or resistances, while they may disregard lower timeframes such as the 1-hour or 15-minute charts.
- Look for a confluence of technical factors
Zones with containing more technical factors, i.e. there is a resistance level, reversal candlestick pattern, moving average all aligned, then there are likely a lot of orders around this area. However, zones with no technical factors (i.e., no significant support, no candlestick patterns, far away from moving averages) are likely to contain a lower number of orders.
- Technicals which take longer to form attract more orders
Think of a resistance or support level that has been tested numerous times - since technical analysis tells us the more a resistance or support level has been tested, the stronger it is, traders will look to place stop orders above/below the resistance/support level. Therefore, a strong support level that has been tested many times will have more stop loss orders than a support that has only been touched once.
Order flow analysis won’t make you profitable overnight but will help you form trading decisions. If you are new to order flow analysis, get a feel for it by watching the order book in real time.
While many traders use technical patterns to make decisions, these patterns are not the cause of the price movements. Instead, the flow of orders is the major determinant of price movements and if you can analyse the order flow accurately, you will then have a good idea of where the price might go in the future.
Order flow analysis can be enhanced by using the volume profile, looking for demand/supply zones on higher timeframes and identifying areas with a confluence of technical factors.