(binned per thread starter's request) Behind Price-Orderflow

Orderflow is the only thing that matters.

Immense thread in the making here if the first post is anything to go by

Thread bookmarked for reading in the morning tomorrow

I just received this email talking about order flow and I thought the analogy was pretty creative. A couple of statements that got the wheels turning.

"Know what other traders are thinking - and you can position yourself to profit from their actions."

"Like Rock Paper Scissors, if you know the likely decisions and actions of your competitor, you'll know how to position yourself for a higher probability of success."

(If this isn't relevant to the thread, let me know and I'll delete the post)

Kinda of long, but here is the whole excerpt from the newsletter:


Rock Paper Scissors - A Trading Analogy!

Yeah... I'm serious!

Rock Paper Scissors!

I know all the other trading educators are talking about poker and the lessons it provides in position sizing and trader psychology. I'd love to sound really cool as well and talk about No-Limit Hold 'em, or Aces over Kings, or all manner of other great-sounding terms. But the fact is that I don't know the first thing about poker. And I figure I'm not the only one.

So, here's one for all of us non-poker nerds... a game that everyone should know, which also provides an excellent lesson for traders.

If you're not familiar with Rock Paper Scissors, check out Wikipedia (http://clicks.aweber.com/y/ct/?l=9o6yZ&m=1agUKKmA7QKukz&b=_Fn4kn1WjCYiOWnyE60hnQ) or the World RPS Society (http://clicks.aweber.com/y/ct/?l=9o6yZ&m=1agUKKmA7QKukz&b=5bJ4si.xaF2vp8fJn.Bt_g) website. That's right... there is a worldwide body dedicated to the promotion of this game, the standardization of its rules and to overseeing the annual International World Championships.

Essentially, Rock Paper Scissors is a game that is widely used for decision making or solving disputes. Two players simultaneously deliver a hand signal representing either a rock (clenched fist), scissors (as per rock, but with the index and middle finger extended representing the two blades of a pair of scissors) or paper (open palm facing down).

 

1. Rock breaks scissors.
2. Scissors cut paper.
3. Paper covers rock.

Typically, in an informal setting the winner will be determined by the best out of three throws, although you may from time to time see a single throw, sudden-death game. If you aspire to attending the World RPS championships, the winner is determined by the best out of three sets, each set being won by the best out of three throws.

If you're confused, don't worry - personal Rock Paper Scissors trainers are available.

So, how does Rock Paper Scissors relate to trading?

Let's first examine the nature of the game. On the surface the result of each game appears to be random. Basically a coin toss, but with three outcomes instead of two - win, lose or draw. On closer examination though you'll recognize that the reality is much different. Unlike a coin toss, the outcome of each game depends on decisions made by the human participants.

And human decision making is NEVER random, particularly when there are high stakes involved.

Your decision about whether to throw rock, paper or scissors, will largely be influenced by your beliefs about your competitors decision. If you know what they're likely to throw, you'll adjust your throw to ensure it beats their choice.

A great example of this is the following exchange between Lisa and Bart in The Simpsons episode #9F16.

 

1. Lisa: "Look, there's only one way to settle this. Rock Paper Scissors."
2. Lisa's thought: "Poor predictable Bart. Always takes rock."
3. Bart's thought: "Good old rock. Nothing beats that."
4. Bart's throw: Rock
5. Lisa's throw: Paper
6. Bart: "D'oh!"
   

The result in this example is far from random. Lisa has managed to win the game through awareness of her opponent's belief systems.

In fact, there appears to be a little bit of Bart Simpson in all of us.

The World RPS Society reports statistics from a number of Rock Paper Scissors sources. The one providing the largest sample comes from the Roshambull application on Facebook, which at the time of reporting had logged over 10 million throws from over 1.6 million games. Statistics in this sample show Rock being thrown 36% of the time as opposed to paper 30% and scissors 34%. It appears that rock is more often the number one choice of Rock Paper Scissors competitors.

If you doubt that psychology plays such a great role in Rock Paper Scissors, schedule a high stakes game against a family member or friend. Something harmless of course, but high stakes - maybe the loser has to wash the winners car each fortnight for the next 12 months. You'll find that your throws are not random at all, but rather you're trying desperately to anticipate your opponents move, exploiting any knowledge you have about the way your opponent thinks.

Before you schedule this game though, let's have a quick look at how you can gain an edge at Rock Paper Scissors.

Firstly, we know from the above studies that the distribution is skewed slightly in favor of rock. So, if we're playing against a novice, the initial edge is available through throwing paper, as paper covers rock. It's a very slight edge, but it's still an edge.

Of course, the strategy will have to change against someone with a little more experience, or in fact anyone who recognizes the non-random nature of the game. These people will be expecting that we'll throw paper, in order to beat their 'obvious' rock. As a result, they're more likely to throw scissors in an attempt to beat our paper. So, instead of paper, we'll throw rock to beat their scissors.

It's all about staying one step ahead of your opponents thought processes.

There's more... watch out for two throws in a row of the same type. People are very wary of being too predictable. If your competitor has produced two throws in a row exactly the same, their next throw is statistically more likely to differ. As an example, let's say they've had two rocks in a row. Not wanting to be too predictable, they'll most likely throw either paper or scissors on the third throw. So, your choice should be scissors, as it'll win against their paper, or draw against their scissors.

Another great option is to suggest a throw to your opponent. Imagine your reaction if we were competing and I said to you, "It's so easy to read you - your next throw is going to be paper." Subconsciously I've implanted in you a desire to avoid paper. You don't want to be predictable, so you'll be more likely to throw either rock or scissors. This makes my choice easier. The edge for me is in throwing rock as it will beat your scissors, or worst-case tie against your rock.

The opposite of this is to state your own intentions before throwing. I could for example say "I'm going to smash you on this final one. Get ready for my rock." The last thing you'd expect now is for me to actually be so stupid as to throw a rock. So you'd be expecting me to throw paper or scissors, leading to your likely choice being scissors in order to get a win or draw. So, I simply give the throw I mentioned - rock - beating your scissors.

Love it!

Of course, it's not all that simple. The World RPS Society website has a strategy guide for sale if you're interested in exploring this further. Remember though, you are playing against humans. Not only are their decisions not random, but they're also often irrational. So, although you might have an edge, you're still playing over a very small sample of games. Be sure to never bet what you can't afford to lose.

So, how is this a trading analogy?

Novices mistakenly think that Rock Paper Scissors is a game of chance.

As we've seen though, Rock Paper Scissors is actually a game of skill and strategy in which success comes from being able to read your opponent, adapting your game to profit from their likely actions. Success is not guaranteed in any particular throw, but if you can successfully get within the mind of your opponent you'll gain an edge which will see you to victory over a series of throws.

Likewise with trading...

Some novices believe it's a game of fundamentals. They'll study the company reports, PE ratios, dividend yields, or wider economic factors such as the retail sales or payroll figures. They aim to find a stock or instrument which is valued differently from what they believe is its true fundamental value. They'll then enter expecting the fundamental factors to push price to their perceived 'correct' value.

Other novices believe it's a game of technicals. They'll use indicators, which are simply a derivative of price, in an attempt to predict future price movement. As price moves in a particular direction the indicators will follow, eventually triggering our novice trader into the market. There is rarely any thought as to what caused the initial price movement, or whether or not the context of the current market supports continued price movement. They operate simply on hope, that the price movement which triggered them into the trade will continue in the same direction.

In fact, neither is correct. Trading is not a game of fundamental or technical analysis.

Like Rock Paper Scissors, trading is a game of understanding people and how they make decisions.

True, your competitor is not one individual. Rather, you trade against the collective market which is made up of millions of other traders and investors all making individual buy and sell decisions.

Price moves in response to the net order flow that results from all these individual buy and sell decisions. If the net order flow is bullish, price will rise. If the net order flow is bearish, price will fall. It's as simple as that. The fundamentals don't move price. They technicals don't move price. Order flow moves price.

So, the game of trading is one of identifying those areas where a significant number of traders are going to feel compelled to take action and then entering before they enter. It doesn't matter whether you use fundamentals or technicals or any other form of analysis. If you can achieve this on a consistent basis, you've got yourself an edge.

Know what other traders are thinking - and you can position yourself to profit from their actions.

There are numerous ways of achieving this. A simple example is the use of chart pattern failures. The more obvious the chart pattern, the better. A technically perfect head and shoulders pattern will produce a large order flow short as price breaks the neckline. But should that pattern fail there will be an even greater order flow long, as the bears scramble to cover their losses. Knowing how traders will act at the point of pattern failure, I can position myself to enter long at this point, to exploit the increase in bullish order flow.

So, examine your trading approach. Whether it's based on fundamental or technical or quantitative or astrological or any other means of analysis, ensure you consider the fact that the market exists because traders make trading decisions. It's not about the technicals or fundamentals. It's about knowing what your competitor is thinking.

Like Rock Paper Scissors, if you know the likely decisions and actions of your competitor, you'll know how to position yourself for a higher probability of success.

Lance Beggs

(c) Copyright 2009. Lance Beggs. All Rights Reserved.

Good quote:

lol, so true!

This is a part of VSA.......nothin new!
Dont get me wrong...I would love to here more....

You wrote;
CONGESTION(Balance)>>TREND(Finding new value)>>CONGESTION(New level attained and finding balance again).

Vsa rule;
Accumulation(buyers coming)>>MARK UP(Finding new value)>>DISTRIBUTION(sellers coming)>>MARK DOWN(Finding new value)
This is rinse and repeat proces, hapens all the time....supply versus demand...it is how the markets work.

Regards

I think you are right. No amount of retail traders could match the weight of the banks when it comes to order flow to actually prevent the way orders are stacked up waiting to be triggered. And most retail traders will be following text book 'Trading for Dummies' strategies (the title says it all). But I think order flow can be very visual if you know what you are looking for. Some use volume as a guage others use areas of congestion and trend to find obvious turning points (my preference).

There is no hanging around for that confirmation candle and a confirmation of the confirmation. I agree that entry is vital and is the key to eliminating risk. The longer it takes to enter the trade at the predefined area, the greater your exposure to risk. Yet traders using order flow need the herd to pay them as the herd typically enters after the fact pushing the price in the original direction of the order flow. For the herd, they typically trade off momentum, using that as a confirmation of the move, realising little that they are themselves the momentum. Many enter too late to benefit from a low risk high probability trade that can only be achieved by entering at the origin of the move. That's why most indicators will not give you very good odds of success in the markets as they all lag and cause people to sell into areas of demand and buy into areas of supply. The herd will always react after the fact buying when the market has already hiked up and selling when the market has already rallied down. It's safety in numbers where those at the back of the herd are the most vulnerable.

Long live the herd.

@Goose
That's the score.
Thanks for the article too,it was a good read.

The below quote is from the article,understanding this quote puts you right in the mix:
When anybody trades and places their bet,there is a point at which enough is enough and they need to cover(damage control).It doesn't matter who they are or how big(the bigger the better though).
When the above plays out,orderflow skews heavily to one side,you process the orderflow with SPEED and your the first one in.Before the next guy even knows what's going on your already up 50p,downed the breakfast and read the sports section in the paper.Get yourself in front.

You don't want to know how many edges there truly are,you would be sickened.
Some folk would kill for one.

@flash
Ever heard of this saying flash:"You don't know what you don't know".
It doesn't really matter if it's new or not,what matters is if it is new to YOU.
To be honest i KNOW there are things that i don't know yet,but you can bet your bottom dollar,i WILL find out.

I bet you would flash lol.
You know i was outside painting today,not feeling well and i was thinking of how deep i could go with regards disclosure of certain inefficiencies(there are quite a few that i know of).
To tell you guys quite honestly,what has been presented here thus far has gone WAAAAY beyond the call of duty.If i go deeper i will have some disgruntled traders looking down at me,I have already received PM'S.This is serious business.
If i kept going with charts and commentary as at the beginning then it would be one edge after another hitting the forum.
My old man today says to me:"You're not going to tell them are you?".
I think to myself:Sheesh,well to be honest i have handed over a lot already lol.Some may not think so,but when you find out yourself you will come to the conclusion that i basically gave you too much.

Ever wondered why threads on orderflow die quickly?
There happens to be reason.
Take it easy.

Cheers

You get this Jig and like i said.....Game Over!!

Cheers

Hi Steve, thanks for an interesting thread.

I take it you're making considerable money (and I mean a lot) from the markets, after all you 'get this'?

I use a scalping system that works on price action to take 20-30 pips each day, I don't use any tools, just plot what I see.

Hi Bleek,

Price action is half the equation the other half you cannot see.
The trouble for most is that the half you cannot see is the half you wish you could.

You will need a very very good understanding of the market to see what many cannot.
Once you attain this understanding,finding edges won't be your problem,your problem will be having too many to use.

I see now looking back why most traders don't even have a hope.
I say that but here's the deal: DON'T EVER QUIT!!!.
Keep your head down Bleek and keep learning.
That's what life and trading are all about,if you continue to learn you WILL grow.

Cheers

Dont know will this help, but market is a perfect beast.....
(in the past I thought it is random....boy, what a mistake...lol)

If it isnt perfect, you got a arbitrage opportunity, and those occurances is rare and impossible for little retail traders to profit from.......
but maybe you can profit from market perfection!??

An excellent thread in the making here, thanks skfx.

Chris

Is this getting in the micro structure of the market then?

Are you refering to the order book or simple volume data in the unseen half? I am currently studying orderflow quite heavily and looking at the market from new angles (new to me anyways). There is a member here at FF named Gaston who does not post very often but claims to be an orderflow trader. Infact he refers to himself as an "orderflow sniper," and in his profile says that he "profits from mispricing." Even though the guy has posted only a handful of times he leaves bits and pieces - clues if you will about how he trades. One thing he said that intreaged me was that he does not use charts. So I got to thinking about it and wondered what the guy is looking at to trade. So far in my studies I have come up with the two possibilites mentioned above.

I notice that you do use charts in referace to the orderflow, but like Gaston you mention this unseen piece of the puzzle. Gaston also mentions liquidity a couple of times in his posts which is, to me, a very important peice of the puzzle. As we all know, liquidity in the market is supplied by limit orders that sit in the good old order book. The limit orders supply finite amounts of liquidity at each price level. When the liquidity is taken out of the market by market orders, price will move to the next available price where liquidity is next available. When the market is frantic and lots of stops are being triggered (market orders) the liquidity drys up quick and things get volatile in a hurry.

The part I am grappling with in regards to reading the orderflow is this: I can only see the best 5 bids and offers in the orderbook and price seems to move so fast (and available liquidity changes) that it is hard to follow (at this point anyways) I know I am searching in the right place though.

Thanks for starting a sweet thread,

Scotty B

Maybe try looking not just at your brokers orderbook but at the market and it's players (the people behind the orders), the reasons why they trade where they trade, their motives, and their objectives, as well as in context of the herds vulnerabilities.

That may sound cryptic but when you think about it it's actually very clear.

I don't watch my brokers book, but I do watch the CME Globex book. Thats the only one that really matters. I understand that the banks move the market. Speculators are just a tiny little portion.

Perhaps we're not as far off each other as you may think?

I had one of those 'hallelujah' moments a few weeks back, I was trying the usual SR trades etc etc but then I saw something between the lines, I saw a heartbeat in the market and the path, shape, journey it took. I change my WHOLE trading strategy. In truth my process is now VERY simple and so far, profitable and accurate to within a pip or two.

I can see the trends, but I don't follow them (sheep), I can see the expected break-outs prior to congestion but don't play them (big players running stops) as I can appreciate what the 'big money' is trying to do. I wait for powerful moves, let the dust settle, then I'm back in trimming the congestion - I don't just trade the very outer edges either.

Interesting thread for sure.

All you need to know is in the first post. Especially this para:

"... when you begin to grasp what orders traders use,why and where,then you may find yourself mixing shoulders with the big boys".

Its not about 5 orders in an order book its about a stack of them. Where are they stacked and why. You are never going to know true order flow even if you had data from your broker as the forex market is not centralised. The information is in the charts which is half the information. The other half (the actual order flows from perhaps hundreds of banks) really doesn't matter. Its knowing why they would place them and where that matters.

I am sure charts aren't needed to do this if you can read the tape.

Speculators in the most part are the fodder simply because of their predictability, I think most of them concentrate too much on the game and not enough on the players, a bit like goose's rock paper scissors analogy article which he posted.

My edge is that I take the counter approach that most would scratch their heads at.

I don't look for these big moves because I don't have the arsenal to hunt the big guys, I'm trading the areas of market fluctuations, the folly, the areas that most would just see as volatile and 'noise'.