Order flow and volume in the forex market: how can it be used?

The spot forex foreign exchange market is the largest financial market in the world with a daily turnover of several trillion dollars.

Every time you submit a new position through your trading platform, your order is processed electronically. However, in some cases, for large clients, transactions are concluded verbally. The main players who accept large orders are participants in the interbank market. Brokers who execute individual transactions also have an order flow book. Order flow can be very valuable to a market maker or broker because it shows the underlying momentum associated with the movements of a currency pair.

Forex order flow is determined by the interbank market, which accounts for approximately half the notional value of all trades executed daily. Market participants in the interbank space are commercial and investment banks. Since the majority of forex market liquidity is channeled through the interbank market, it is important to analyze how these players use order flow information to make trading decisions.

Order flow in the forex market is determined by trades that pass through large financial institutions, where counterparties range from hedge funds, central banks and portfolio managers. Most of the flow of currency orders passes through 15 financial institutions. These include some of the largest commercial banks that have dedicated forex trading desks, including Chase, Citi, Bank of America, Deutsche Bank.

What is order flow?

Financial institutions have thousands of customers around the world who at some point may need to carry out a currency transaction. Banks have clients who are involved in investment banking and corporate finance, which may extend to the purchase or sale of a particular currency pair. These companies will also be active in the interest rate, commodity and stock markets.

The key to using order flow trading is to determine the depth of the market based on the exchange rates at which clients want to trade. Order flow is like a list of trades that will occur as the market moves. Since many corporate bank clients are relatively indifferent to prices and do not try to extract every possible item from the market, they allow the dealer to enter the market at a level at which they feel comfortable making their trade. This is a limit order, but it can also be a stop order if the client is trying to enter a breakout trade.

Trade order flow allows the dealer to see the specific price at which a trade will appear in the market, as well as the volume of the trade. This information is extremely valuable and allows the dealer to generate significant revenue using this information.

The order flow will show each level at which a transaction can occur. The size of each trade is indicated along with the volume of trades. Each order flow book is different and shows you the volume along with the price. For example, a trader who trades EUR/USD will have a different order flow book than a trader who trades USD/JPY.

Most dealers use order books to their advantage. However, the client almost always has the option to cancel the transaction if the exchange rate does not reach the desired level.

Thus, if a dealer decides that he wants to short the EUR/USD currency pair by 5 pips before the trigger to sell a large amount of that currency is reached, and the order is canceled just before the level is reached, the dealer may be stuck with a trade that has already been move in the opposite direction.

The order book will typically have large volume trades further away from the spot price and many smaller volume trades near the spot price. Many times a major market participant will base part of their risk management on their order book. For example, if there are large sell orders above the current exchange rate, the dealer can use these levels as potential resistance.

Many traders will use order flow analysis to further confirm that the market is moving in a certain direction.

Consider the image above. If a dealer has a hedge fund client who has a buy stop order to buy a large amount of USD/JPY at 113.90, the dealer may buy more volume than he needs to cover his position. Thus, if the client wants to buy 30 million USD/JPY, then the dealer can buy 40 million and catch the move up when the level is broken.

Although the order flow book is extremely important, in some cases it will not work because clients know how order flow can benefit the dealer. A hedge fund may decide to enter a position with one dealer and exit that position with another. While these scenarios may result in additional credit being drawn down, it can be reversed after a few days, ensuring that neither dealer will know exactly what their customer was doing.

Dealers will sometimes have overlapping order flow as the client decides to trade a cross pair. While dealers execute cross-pair trades, most of the liquidity is in the major currency pairs. For this reason, an EUR/USD trader can have a mutually beneficial dollar trade with a trader who trades USD/JPY.

Forex dealers try to lock in profits by buying a currency pair at the bid price and selling at the ask price. This allows the dealer to profit from the spread. For currency pairs that are very liquid, such as EUR/USD, the bid spread can be as low as half a pip, while on some exotic currency pairs, the bid spread can be as high as 20 pips.

Market sentiment and volume

Order flow volume is difficult to measure unless you are a foreign exchange dealer. Most dealers have access to over-the-counter platforms such as Electronic Broking Services and Thomson Reuters Dealing.

This allows them to create internal indicators of order flow. If you are a retail client, you will not be able to see the order flow and volumes in the market, but you will be able to use a different mechanism to measure the flow. For example, you can measure the volume of futures and ETFs, as well as options on these products.

Futures volume

Volume in futures markets describes the overall trading activity for any given contract. Futures contracts on currency pairs can be very liquid and subject to arbitrage by dealers to ensure that their values ​​are identical to those in the over-the-counter market. If volume increases at a certain level and time, it can be used in the same way that a dealer uses order flow. The difference is that you can't see it in advance.

You can also use volume in tandem with open interest to gauge sentiment. Open interest describes the total number of open contracts. This indicator is updated at the end of the trading session, while volume is usually updated during the trading session. If volume is greater than open interest, you know there are a lot of new trades in the market. If it is less than open interest, it is difficult to determine whether the trades are new or whether positions are being fixed.

Typically, an increase in volume and open interest is confirmation of a new position. At the same time, an increase in volume and a decrease in open interest is the liquidation of the previous position.

Option volume

You can also evaluate option volume on both futures and ETFs to see the orders that have moved through the market and are generating volume. At the same time, there should be unusual activity in the options market. Unusual activity is described as volume greater than 200% relative to volume over the past 30 days and new volume exceeding the current open interest for the option. If this happens when the market is pushing through support or resistance levels, there is a possibility that there was significant order flow at that particular level.

Where can I use order flow?

Capital markets are essentially auction markets, and the foreign exchange market is the largest auction market in the world. Every day, buyers and sellers come to the market to get the best deal.

Every transaction that takes place requires a buyer and a seller. When buyers lower their bid price and sellers lower their bid price to complete a trade, the price of the security in question must decline. The opposite can be said when buyers raise the price and sellers raise the listing price.

A market that is not an auction market is a negotiable market. In a negotiated market, a broker contacts buyers and sellers and negotiates specific purchase and sale prices with them. You see this all the time in real estate, where you typically need a broker to find a seller to negotiate a sale.

In harmonized markets, which are often opaque, fair value can be difficult to determine. Order flow is less important in the short term for consistent markets. Futures trading, on the other hand, provides traders with sufficient volume to determine a fair price.

Let's imagine a word auction. If the transactions are slow, the auctioneer will speak slowly and his voice may be monotone. When the number of transactions increases, the auctioneer will talk quickly and try to generate additional interest. Futures markets are similar, and when volume rises, the market is trying to tell us something.

It is impossible to understand why some traders buy a security at a price that is above fair value or sell below it, but understanding how fair value can be interpreted by analyzing market size can improve a trader's ability to make informed decisions and make better trades.

Technical volume indicators

There are several technical volume indicators that can be used to assess buying and selling pressure. The balance indicator is one of the best. The indicator is focused on using volume to search for divergence patterns. For example, if prices move higher on weak volume, you will know that the move is not confirmed.

Traders can also use volume as a momentum indicator to determine whether a trend in volume is increasing or decreasing. For example, you can use a momentum volume indicator such as the Percentage Volume Oscillator, which is similar to the moving average convergence divergence indicator.

This technical indicator is ideal for assessing order flow when the market breaks out of an important level. A breakout on strong volume confirms a breakout of either support or resistance. Changes in the direction of a security accompanied by volume indicate that the market consensus believes the price will move. When volume does not accompany a price change, the movement is usually suspicious. Volume indicators can help a trader with strategies as well as entering the market at the most effective price.

Order flow is a very important market assessment mechanism for both dealers and individual traders. While dealers have a book of order flow and can see when the market may be moving or stopping, price action ultimately shows the movement of the market and can be used by individual traders by estimating volume.