Exploiting Order Flow and Liquidation Pressures
In my 20 plus years as a trader, and having experienced just about everything (positive and negative) you can experience as a trader, I can say with complete conviction that quality analysis of a market is not what it appears to be. There is a fundamental underlying structure to any market that is dynamic; it changes from moment to moment. Developing an understanding of those changes and applying that knowledge consistently is what will make your trading really reach its full potential. This is much more than “technical analysis” in my opinion.
Most successful traders will tell you that by far the most critical part of their success has been a high level of personal understanding. Successful traders know why they do what they do the way they do it. Equally important is a solid understanding of the bedrock underlying structure of the market they trade. Successful traders can tell you exactly what is creating price action and this is often something that has very little to do with market fundamentals or market technicals; it has to do with psychology. This is why successful traders have absolutely no conflict of any kind selling into a massive rally or buying into a hard break. They know why that market is exhibiting violent price swings and they know what will be coming next.
Today we are going to discuss the fundamentals of market structure and how to develop an understanding of when a change to the structure is coming. What to do next becomes much more definable when you see the market as a dynamic unfolding event rather than just a series of prices. Once you have a better understanding of the market structure and how it changes you can develop the skill and confidence to do the things that successful traders do without hesitation. At the very least it can help you stay out of trades that don’t have a high probability of success.
I want to start by discussing an important basic to trading. No matter how you want to slice it, once you enter a market by initiating your position at some point you must liquidate. Forget about gains or losses for a moment or about how much time you might need to liquidate; the fact is you must liquidate. Every traded contract has a last trading day. If you are still in after that you are either a hedger of the product itself (making delivery) or a consumer of that product (taking delivery). If you are not a hedger or consumer of that product; then you are the speculator and you must liquidate before the last trading day. How much money you have made or lost is not the issue; the issue is that you can’t stay in forever. It is this liquidation pressure on the bulk of the market participants (over 98% of contracts traded) that creates the order flow and the price changes you are attempting to profit from. At every moment there is a group of traders liquidating. It is this liquidation that drives pricing.
Now ask yourself the question “What causes people to liquidate?” The correct answer is “either a profit or a loss”. The issue as far as exploiting this liquidation pressure is concerned is “who is that?”
If you stop to think about it, a losing trade exerts more of this liquidation pressure than a winning trade for very sound reasons. First, the losing trader must liquidate while the winning trader can choose to liquidate. Therefore the urge to action is a higher state of pressure in the loser. At some point the losing trader has no more financial integrity to hold his position. Sometimes the losing trader has the ability to cut his loss on his own, sometimes he needs his broker to do it, sometimes the exchange liquidates because he is debit; but in any case the loss is big enough that a forced liquidation takes place. In the case of the winner, this force is less because he has a lead on the market. An open trade winning position allows a person to think a bit longer before taking action. At some point the open trade winner is “big enough” that the winner will want to take it. He will liquidate. But that choice can happen anytime; no broker or exchange will force you to liquidate a winning position and force you to take a check home. It is this slight difference in pressure that makes prices move; because only one side of the market is in a state where they must enter an order. Therefore, a large amount of price action represents people taking losses; whether they want to or not. Some of the order flow moment to moment represents losing trades being liquidated.
Suppose you know who that is? Wouldn’t you be in a better position to anticipate what sort of price action would be coming next?
For the sake of illustration, let’s ask a few basic questions about a market that has been in a steady price rise for a reasonable amount of time:
How can I know when they are liquidating?
If a market has been in a steady climb for a period of time it would be safe to say that the traders holding open longs are the winners. The holders of short positions are losing money and at some point they will be forced to liquidate. Should prices advance into resting orders above the market, and if those orders are buy-stops, then the market is liquidating losing shorts for the most part (Why do you think they are called “stop-loss” orders?) Now if at this moment we do a little homework, we can build a case for a high probability trade. On closer examination we discover that Open Interest (O/I) has not changed very much on this advance into the liquidating orders. Although the losing shorts are now out of the market, they have been replaced; otherwise O/I would go down to reflect them leaving the market. That can EITHER be additional long positions or brand new shorts. Let’s say a little of both. We look at the volume for the day and see this was a typical day as far as volume is concerned. The next trading day we see a sharp advance in price putting the new longs from yesterday’s trade into profits and the new shorts at a loss. The day after that, we see another advance into buy-stops and we can deduce that the new losing shorts have covered. If at this point we ALSO see a drop in O/I, we know that nobody new came to the table to play and most likely after three solid days of price advance a few old longs decided to take profits.
Now, this is an illustration—not intended to be a critical discussion of V/OI but I want you to think a few things through. What continued to create the price advance? Enough buy orders to trigger the buy stops. As long as that structure continues, the market will continue to climb in price as the losing traders continue to be forced out of the market and new potential losing shorts replace them. This is one reason a bull market can become “overbought” and yet continue to advance for days or even weeks. Consequently, once the advance gets “too high” from the winners point of view—they will choose to liquidate at about the same time the losers are forced out. This is shown as high Volume with a drop in Open Interest. Both sides are quitting. The potential for a reversal is now higher and represents an excellent new short opportunity.
Of course, a potential top in a market will not form quite this simply but the central underlying change to the market structure is what creates a top. Or a bottom. The fact is, once the losing positions are forced out; the market is running out of order flow UNLESS new traders are replacing them. This is why buying into a break when the sell-stops are triggered can be such a profitable thing to do; if no new sellers are entering new positions the market will run out of selling orders. All that is needed to reverse prices is for a few shorts from above the market to liquidate their winning positions. Once that happens, that will drive the losing shorts that entered late to liquidate creating a “buy order” imbalance. Now you have a rise in price. If the new buyers open a new long at the same time the imbalance will be substantial and that is what creates a reversal. For the most part, it is this ebb and flow within the order-flow that creates what you see on the screen as price action. But what is actually creating that order-flow is the small amount of time difference between the loser being forced to liquidate and the winner choosing to liquidate. Often V/OI can provide good clues that this scenario is developing. Always remember that it takes a little time to unfold so allow yourself to use multiple time frames when looking for the most likely spots.
If you are interested in learning more about the nature of liquidation and order flow, please join me on Thursday December 14, 2006 for a free online webinar sponsored by the Chicago Board of Trade at 11:30 AM CST. Click here to view details and sign up: