Friday, May 31, 2013

Order flow and its impact on chart highs and lows

Last night as I drifted into sleep, my mind churned over order flow and I developed an idea. How do you tell when a market is turning?
Price action traders would tell you to look for price reversal patterns, but in my backtests, these signals alone do not provide a tradable edge. While these patterns do suggest a short-term reversal, that's all they are, short-term.
Trading these signals at significant support and resistance levels may add some edge, but many times they don't work. Could I add something more to add to this edge?
I thought about order flow, and how the market can show its hand on the charts. I thought about the actual pattern of a market reversal. If we have a bullish trend, we normally see higher highs and higher lows. We only a see a reversal when this pattern is broken and we see a lower high.
Why do we see a lower high? In terms of order flow, we are now seeing an increase in sell orders and/or a decrease in buy orders. Buy orders are being exhausted. But more importantly, they are being exhausted earlier. This is how we know that the market has a higher likelihood of turning. And I suspect this likelihood increases on the higher timeframes since it takes a lot more money to move the market, reducing the possibility of manipulation.
Here's an example of what I'm talking about. It's the AUDSGD on the daily timeframe and we see that price has hit a support level. But we don't know what will happen next. Will it break through support and continue to fall, or will it reverse?

If we want to trade a reversal, we can wait for a price action entry signal. But, if we are to trade with order flow, we'd want this entry signal to signify a higher low. This tells us that shorts are being exhausted earlier, signalling a growing glut in longs.

Intuitively, I think this can add an extra edge. Trading reversals is always risky since you're going against the longer-term trend. However, I feel this is a good way of filtering an entry.

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