As the Bitcoin price and the rest of the crypto market are primarily driven by technical analysis and the wealth of charting software available, the order book is a powerful tool to gauge the probabilities of market direction.
The reading of buying and sell demand in the order book is called “order flow.” This can help day traders who are scalping the market to improve their profitability.
But order flow also helps all types of traders to identify spoof orders outside of day traders. Especially in a market that is notorious for fake volumes
“Spoofing” is a practice in which traders attempt to give an artificial impression of market conditions by entering and quickly canceling large buy or sell orders on an exchange to manipulate prices.
Order flow is one of the oldest stock trading techniques, typically used by day traders or “scalpers” who place many short-term orders for only minor movements in the market. It can be used in conjunction with technical analysis to
- Define entries and exits
- determine whether to use market or limit orders instead of arbitrary entries and stop losses, and
- to help manage a position by estimating the probability of a price reversal against your trade.
Technical analysis fulfills our innate human desire to see patterns in randomness. This is a psychological phenomenon known as pareidolia. Therefore, we see self-fulfilling patterns in the form of head-and-shoulders, triangles, or other widely known chart formations.
Doubting the raison d’être of technical analysis happens in only a few circles nowadays and is mostly evidence of a lack of knowledge about the subject. In fact, there are hardly any professional traders left who do not use technical analysis at some point in their analysis.
Order flow trading is used by institutional and high-frequency traders who are less interested in the multitude of indicators and charting software. For them, supply and demand are at the forefront of their analysis.
Order flow is most commonly used in large liquid markets such as US treasuries and futures, where traders even trade purely off the books and ignore charts altogether. However, order flow trading will be discretionary for most retail traders, as trying to automate the trading rules in code requires a high level of programming knowledge.
But now, let’s get to how you can read an order book properly and what you can use order flow trading for.
At first glance, the order book may seem overwhelming for newcomers with its flashing and constantly changing data. But in fact, its structure is usually quite clear and helpful for the trader.
The order book indicates at a glance the depth of supply (ask/offer) and demand (bid) in the market, also known as market depth (DOM). Reading deeper shows price areas where there is support and resistance (volume profiles in the shaded green and red bars) that can be used for better entry and exit to identify possible turning points.
In day trading, picking entries and exits at tight spreads is key to maximizing satoshis or SATs, and unlike position or swing trading, the use of stop losses can be counterproductive in scalping.
1 Satoshi is the smallest unit of Bitcoin and is equal to 0.00000001BTC.
Reading and anticipating the order flow can get you out of a trade before it turns against you and you lose more SATs up to your stop loss. This is also the premise under which high-frequency trading works at all.
The order book only shows limit orders (known as “market makers” on futures platforms), and the market orders (“market takers”) are only visible when a limit order is hit. Like the haggling over the price that takes place in a physical market between buyers and sellers, an order book shows the tug-of-war over price where one side is overwhelmed by either too many sellers or too many buyers. The direction of the price depends on which side can muster more force.
A trader can use order flow to confirm the support and resistance levels that he has marked on the chart. Typically, you can expect a cluster of large orders around the technical levels you have selected on the chart to confirm your thesis.
However, this does not mean that these levels will hold. For example, be wary of relying on an oversized order acting as support below your price. It could be a spoof order, and instead of acting as support, it could dissipate into nothingness.
When a trade is executed, it means that a limit order has hit a market order. In other words, either a buyer or a seller has agreed to the limit price. The following insights apply:
- Buying power is created when buy market orders meet sell limit orders.
- Downward selling power is created when sell market orders meet buy limit orders.
Always remember that larger players will rarely be overt about how they position themselves in the market. Like poker Texas holdem, market orders are the hand that each player at the table holds face down in their hand, while limit orders are the community cards in the middle.
So when there is a high demand from buyers, you can’t tell by large buy-limit orders stacking up below the current market price. Instead, you recognize it by selling orders being executed quickly due to larger buy market orders from competing buyers who all want to secure the best price before the price rises further. Therefore, the following four market forces apply to order flow:
- Buy limit orders (bids) represent a weak upward force.
- Sell limit orders (offers/orders) represent a weak downward force.
- Buy market orders (buys) represent a strong upward force.
- Sell market orders (sells) represent a strong downward force.
The volume we see in the book at a given price is the sum of all orders at that price. While aggregating orders for the same price makes the order book clearer, it also makes it difficult to tell whether it is an individual or a group of players. Recognizing these positions is a skill acquired by reading the book, which allows you to get behind the right side of the swing.
The market depth chart is a visual representation of the volume of buy/sell orders at their respective price increments in the order book. It is shown as a proportion of the cumulative order volume on both sides of the book. This is because the order book itself only shows the total volume. Therefore, the steeper the steps, the higher the volume at that price.
The market depth is constantly changing as limit orders on both the buy and sell sides meet market orders, or new ones are added. As a result, there is more cumulative volume on the sell-side in this snapshot but more stopping power on the buy-side with support at 0.00000002BTC.
The spread is the widening and contracting price difference between the highest bid and the lowest offer. Thinned markets are more easily pushed around with larger orders, leading to large price jumps.
Limit orders provide liquidity, and market orders consume liquidity. So in an uptrend, buy market orders consume the liquidity above them (limit sell orders) until it hits a block of sell liquidity too large to be consumed by the buy-side (vice versa in a downtrend).
These large block orders are also called “iceberg” orders because only part of the order is visible in the book, and the rest is hidden liquidity that can act as a stopping force for a trend reversal. So again, it is advisable to exercise caution due to spoof orders.
You, as a trader, can use many tools to supplement order flow in your trading decisions. One of the most important methods is volume profiling. The Point Of Interest (POC) and volume clustering play a significant role here.
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Source: https://medium.com/coinmonks/bitcoin-and-altcoin-trading-tip-what-is-order-flow-trading-273b87442be1?source=rss——-8—————–cryptocurrency
