Order Flow Fundamentals in Futures Trading Explained Step By Step

Deciphering Order Flow – Understanding The Mechanism That Moves Price

 

To understand the mechanism that moves the price up or down we have to learn the interplay between the Depth of Market on one side and Market Orders on the other hand. This interplay is the Order Flow. We used SierraChart Trading Platform for the illustration.

The Current Price is the last price in which a trade took place. This last trade could have taken place either at the Best Bid Price or at the Best Ask Price. Those two terms will make sense in a minute once we understand what the Depth of Market is.

The Depth of Market is the total Size of limit buy or sell orders that are placed at each price. It is often called Liquidity, Limit Orders, Passive Orders or The Book. Take a look at figure #1.

Order Flow Figure #1:  The Emini-S&P500 DOM ( Sierra Chart charting and trading platform.)

Depth_of_Market(DOM) Diagram of Order Flow

In Figure #1 we see the standard visual representation of the Depth of Market. The price ladder that we see in figure #1 is called the DOM which stands for Depth of Market. This ladder often serves also for placing trade orders and then its proper name is DOME (Depth of Market Execution), but most traders just call it the DOM in both cases.

The middle column shows the price. The left column shows the 10 Bid levels (green background), and the right column shows the 10 Ask levels (red background). The numbers in the Bid and Ask columns tell us how many contracts (or stocks or lots) are waiting as limit buy orders (Bids) or as limit sell orders (asks) at each price. Different exchanges supply data about a different number of Depth of Market price levels. With futures contracts, we usually get 10 levels of bids and 10 levels of asks. Obviously, there are limit orders placed above the 10 ask levels that we see and below the 10 bid levels that we see, but we know nothing about them.  The price of the lowest of the 10 Ask levels is called the Best Ask Price, and the price of the highest of the 10 Bid levels is called the Best Bid Price.

During trading hours the current price fluctuates between the Best Bid Price and the Best Ask Price. In Figure #1 we see that the current price is at the Best Ask price.  What this means is that the last trade happened at the Best Ask price. Now comes the point that is most important to understand – No matter how many contracts are waiting as buy limit orders at the Bid levels or as sell limit orders at the Ask levels no trade will ever take place until a buy or Sell Market Order will be placed. When a trader places a buy Market order, he is announcing that he wants to buy X contract right now at the Best Ask price. When a trader places a sell Market order, he is announcing that he wants to sell X contract right now at the Best Bid price. Buy market orders are always matched against the Sell limit orders waiting at the Best Ask price and sell market orders are always matched against buy limit orders waiting at the Best Bid price.

Now we can understand why the highest of the bid levels is called the Best Bid and the lowest of the Ask levels is referred to as the Best Ask. When a trader wants to sell at the market (sell with a market order) he/she obviously intends to sell at the highest price available, so the highest bid price is his best option. When a trader wants to buy at the market he wants to buy at the lowest possible price and therefore the lowest ask price is his best option. The Spread is the distance between the Best Bid price and the Best Ask price.

Visualizing the Market Orders – Just as the DOM visualizes the Depth of Market data (limit orders) we also have a tool that visualizes the market orders. The common names for this tool are FootPrint Charts (Market Delta platform) or Numbers Bars (Sierra Chart platform). Let’s take a look at figure #2.

Order Flow Figure #2: A Numbers Bars chart (Sierra Chart platform).

Number Bars Order Flow

Figure #2 shows a 5-minute bars chart with Numbers Bars (Sierra Chart). The numbers at each price show Bid Volume x Ask Volume.

The Bid Volume is – The number of Contracts/Stocks/Lots that were sold with market orders when this specific price was the Best Bid price.

The Ask Volume is – The number of Contracts/Stocks/Lots that were bought with market orders when this specific price was the Best Ask price.

Don’t confuse Bid Size/Ask Size with Bid Volume/Ask Volume. The Bid Size/Ask Size is the total Size of limit buy or sell orders that are placed at each price while the Bid Volume/Ask Volume is the total volume of buy or sell market orders that traded at each price.

While the DOM shows the limit orders that are waiting to get filled the Footprints/Numbers, Bars charts show what actually traded at each price.

So what makes the price move?Let’s look at figure #3.  We see that at the moment this screenshot was taken we had a total of 193 contracts waiting as buy limit orders at the Best Bid price 2164.75 and 153 contracts waiting as sell limit orders at the Best Ask price 2165.00.  The current price is 2165.00 which means that the last trade so far happened at the Best Ask price. Figure #3 is static but we have to remember is that the numbers on the DOM keep on changing all the time because of two reasons:

  1. When a trader places a buy market order of X contracts, we will right away see a reduction of 10 contracts from the Ask Size at the Best Ask price on the DOM and an addition of 10 contracts to the Ask Volume at the Best Ask price on the Numbers Bars/Footprints chart. When a trader places a sell market order of X contracts, then we will right away see a reduction of 10 contracts from the Bid Size at the Best Bid price on the DOM and an addition of 10 contracts to the Bid Volume at the Best Bid price on the Numbers Bars/Footprints chart.

Order Flow Figure #3: A DOM attached to a Numbers Bars chart (using Sierra Chart’s Chart DOM)

DOM_with_Number_BarsExample – On figure #3 we have 153 contracts at the Best Ask price (2165.00). If at this moment a trader places a buy market order of 10 contracts we will right away see that the Ask Size at 2165.00 will change to 143 because the buy market order of 10 contracts was matched with 10 of the 153 contracts that were waiting as sell limit orders at 2165.00 and they got filled leaving 143 contracts still waiting to get filled against new buy market orders (153 – 10 = 143). On the Numbers Bars chart, we will see that the 255 contracts that were bought so far with market orders at the Best Ask price 2165.00 will change to 265 because 10 more were just bought at the market.

On the Bid side, we have 193 contracts at the Best Bid price (2164.75). If at this moment a trader places a sell market order of 10 contracts we will right away see that the Bid Size at 2164.75 will change to 183 because the sell market order of 10 contracts was matched with 10 of the 193 contracts that were waiting as buy limit orders at 2164.75 and they got filled leaving 183 contracts still waiting to get filled against new sell market orders (193 – 10 = 183). On the Numbers Bars chart, we will see that the 495 contracts that were sold so far with market orders at the Best Bid price 2164.75 will change to 505 because 10 more were just sold at market.

  1. The second reason for the continuous change of the Bid Sizes and Ask Sizes on the DOM is that traders add limit orders and cancel limit orders. Some of the adding and canceling have to do with legit trading decisions, and some reflect manipulation efforts (Spoofing).

So far we understood how price fluctuates between the Best Bid and Best Ask. The next question to ask ourselves is – What is required for the price to move one tick higher to the next Best Ask price or one tick lower to the next Best Bid price?

Order Flow Figure #4 :

Best_Bid_Best_Ask_AnalysisOn figure #4 we see the 153 contracts waiting as limit sell orders at the Best Ask price 2165.00. If at this moment traders buy 153 contracts at market then all 153 contracts waiting at the Best Ask price will get filled and we will have zero contracts at 2165.00 which will immediately make 2165.25 the new Best Ask price and the next buy market orders will be matched with sell limit orders at the new Best Ask price 2165.25. The 255 contracts that we see on the Ask Volume side of the Numbers Bars at 2165.00 will increase to 408 (255+153=408). The same story applies to the downside. We need 193 contracts to be sold at market in order to get the entire buy limit orders at the Best Bid price 2164.75 filled and then the next sell market orders will be matched against limit buy orders at the new Best Bid price 2164.50.

In liquid markets, there are always limit buy orders waiting at the next bid price of sell limit orders waiting at the next ask price, and therefore price moves in one tick jumps. With less liquid markets the next Best Bid price or next Best Ask price may be more than one tick away, and we may see price jumping more than one tick leaving some price levels untraded behind. The spread will almost always remain 1 tick in liquid markets (in our experience) because as soon as the Best Ask jump one tick to the upside traders will quickly place buy limit orders at the level that was the previous Best Ask and is now available for the bids. Or as soon as the Best Bid jump one tick to the downside traders quickly place sell limit orders at the level that was the previous Best Bid and is now available for the asks.

During important economic data releases or news events, traders tend to withdraw limit orders, and the book becomes much “thinner” and then even in liquid markets the spread may increase to more than one tick for a very short time.

 

Appendix  #1 – Some advanced features of the Sierra Chart DOM.

Figure #5 shows the Sierra Chart DOM with a few additional features. You can see 2 new columns.

Figure #5:                                                                           

SierraChart DOMThe column to the right of the bid column shows the Recent Bid Volume which is the Bid Volume that traded at each price level the last time this level was the Best Bid price. The column to the left of the ask column shows the Recent Ask Volume which is the Ask Volume that traded at each price level the last time this level was the Best Ask price. If price moved away from this Best Bid or ask price then the Bid or Ask Volumes at those prices will reset to zero the next time they become Best Bid or ask prices.

To the left of the DOM, we can add different studies. In this case, we see a Volume profile, some intraday highs and lows and a VWAP with its 3 standard deviations.

 

 

Appendix  #2 – Some advanced features of the Sierra Chart Numbers Bars charts.

Figure #6:

number bars advanced features

The Numbers Bars chart on Figure #6 displays a few advanced features. The green and red fonts alert us that the diagonal comparison between the Ask Volume, when a price was the Best Ask and the Bid Volume at the accordant Best Bid price, gives a ratio value that is larger than a specific threshold value ( 3 in this case). The comparison is called diagonal because the Best Ask price is on the right side of the “x” and is (usually) one tick higher than the Best Bid price on the left side of the “x”. If the Ask Volume is larger than the Bid Volume, then the color is green and if vice versa is then red.

The Numbers Bars are overlaid on top of Volume Profiles that give us a good visualization of the volume distribution within each bar. The VPOC of each bar (the price with the highest volume) is extended until future intersection (dashed magenta lines). The green and red boxes show us the “body” of each bar and the yellow and magenta box surround the lowest volume price and highest volume price respectively.

At the bottom, we have the “Numbers Bars Calculated Values” study that offers a large variety of statistical calculation regarding the Ask and Bid Volumes of each bar.

To the right we see a Volume Profile with Peaks and Valleys (Peaks – green dotted lines and Valleys – red dotted lines) and at the very right edge we have a Chart DOM which is a DOM that is attached to the chart in a way that makes it much easier to relate the actual trading information at each price (the Numbers Bars) to the Depth of Market information at the same price.

Platforms that utilize Order Flow:

  1. Sierrachart 
  2. Investor RT 
  3. Bookmap
  4. Jigsaw

There is a substantial risk of loss in futures trading. Past performance is not indicative of future results. 

 

 

 

 

 

 

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