By Jack Broz, www.themarlinletter.com

The more time I spend working with new traders, the clearer it becomes to me that what these traders are missing in their quest to become profitable is the ability to read order flow. Often times, I find that these traders know more about technical analysis than professional traders who have been making a living in the pits or on the screen for 10, 15, or even 20 years.  If you use technical analysis to determine entry points for trades, you probably have found that many, many times, as soon as you get long - the market breaks. Or, no sooner do you get short - and the market rallies. Or...you enter a trade, and just watch the market chop around your entry price for several minutes.  (There's no reward in that trade either).  How about exiting trades? How many times have you just gotten out of a position - and the market immediately races your way several more ticks? Now, rest assured that these same things also happen to professional traders; however, they happen to the novice trader so often that the trader finds it difficult to become profitable.

I propose that what the novice trader is missing is a correct gauge of the order flow, that is, what the buyers and sellers in the market are doing.  I've heard many traders refer to what I'm discussing as "timing" as in, "I had the right idea, but my timing was off."  It's the same thing; a trader who can correctly read the flow of bids and offers into the market place will be better able to time his trade entries and exits. 

You can begin to learn the order flow on this website (www.cbot.com/dow).  On the upper right of the screen, you'll see, Now is the time. It's your move. Just below there, you'll see Simulated Order Book or Click Here to see the Live Book.  Click on either of those and a form will pop up. Upon completing the form, a 5-minute real time mini-sized Dow bar chart and the Order Book will appear. Select Launch The Book In A New Window...and you'll be looking at the order flow that the professionals are.

Looking at the order book, you will see that the left side shows the buy orders, and the right side the sell orders.  The top price on the left side is the current bid; the top price on the right side is the current offer. (Above the book, the Last shows the last traded price; the Change indicates the net change from the previous settle).  The numbers next to the prices in the book show the actual quantity at each price.  For example, 42  9736 on the left side means there are 42 orders to buy at the price of 9736.  If we see 38 9738 in a row on the right side, we know that there are 38 orders to sell at the price of 9738.  However, keep in mind that what you are seeing is the live book and that the prices - and especially the quantities - will continually change. 

(Note: In an Exchange-designated fast market, the changes in the book will be even more pronounced. While there are strategies for trading a fast market, the purpose of this article is to introduce traders to the benefits of reading order flow; traders in the beginning stages of learning to use the order book should not trade fast markets.) 

Now, what is critical is the volume of the best five bids versus the volume of the best 5 offers. As you read that, perhaps you're thinking, "How in the world can I keep up with something that is ever-changing?"  Well, first of all, you only need to "guesstimate" the total volume of the best 5 bids versus the best 5 offers. If the book shows:

42 9736            38 9737
16 9735            18 9738
22 9734            16 9739   
87 9733            40 9740
38 9732            40 9741

scan each "tens" column; it suffices to say that there are more bids than offers in the book.  (We would expect this to push the market higher).  Suppose the book changed to this scenario:

39 9736            28 9737
42 9735            14 9738
93 9734            20 9739   
43 9733            33 9740                                                                                       
40 9732            40 9741

The first thing to look at is the Last (above the order book)...suppose 9737 appears there. This change in the order book tells us that 9737 traded perhaps as many as 10 times (the offer volume is 10 less and the offer price traded).  We can also deduct that the buyers are becoming more willing to buy: the quantity of 87 that was on the 9733 bid appears to have moved up to 9734...the quantity of 22 previously bid at 9734 appears to now be bid at 9735.  

Now the book changes to:

66 9737             9 9738
55 9736            11 9739
40 9735            35 9740
52 9734            40 9741
38 9733            16 9742   

What we see here is that the buyers have taken all the 9737 offers - and bid to buy more. That's bullish.  Furthermore, some of the sellers at 9738 pulled their offers - they are less eager to sell than they were a few seconds ago. That's bullish...some of the 9736 bids went up to 9637 - also bullish.  A guesstimate of the top 5 rows show the bid size is still larger than the offer side...bullish.  About the only thing that is bearish is that the size at 9741 hasn't budged. 

Two minutes later, the book shows:

  9 9752               7   9753
17 9751             50   9754
22 9750            109   9755
44 9749             87   9756
20 9748              55   9757

The first thing that jumps out at is that now the offer side of the order book has the better size.  This is the first hint that perhaps it's time to take profits.  We also see huge size at 9755. That kind of size can be interpreted as longs looking to take profits, institutional sellers anticipating resistance at 9755, or, institutions trying to push the market back down so they can re-establish long positions. 

Now, please understand that reading order flow is by no means an exact science.  However, by studying the order book every day, you will begin to notice nuances - patterns - in the way market participants place orders, pull orders, etc.  When you're watching order flow, you're watching every market participant - the institutions, hedgers, large speculators, and small traders.   On one end of that spectrum are the 1 and 2-lot traders placing orders in an attempt to establish a trade. On the other end of the spectrum are the institutions and large traders who, besides looking for trades, will use the book in an attempt to bluff other traders.  An example of how they might do this is by placing large buy orders and hoping other traders bid in front of those orders.  The institution will then sell those bids.  In many ways it's a game of cat-and-mouse that often goes unnoticed by new traders. 

As you learn what is happening in the market by watching the book, combine that insight with information obtained from studying the 5-minute chart (also found at www.cbot.com/dow).  Suppose the 5-minute chart shows that the market has rallied up to 9775 twice during the session - only to fail and sag back to 9735-38. This tells us that the market is viewing 9775 and 9735 as important areas.   The key is to use the order book as trade nears those prices to determine if the market is still viewing 9775 as resistance, and 9735 as support. 

Continuing with our previous examples, let's say the market falls back after uncovering the 109 offered at 9755.  A few minutes later we see this in the book:

62 9735            13 9736
16 9734            22 9737
50 9733            18 9738
50 9732            11 9739   
33 9731            22 9740

This tells us that the market is still viewing the 9735 area as support, and we can therefore look to buy this area. 

I'd like to conclude with a few other thoughts on the order book. While I have discussed the top 5 rows of the bid/offer in this paper, you will notice that the book shows the market bid and offer 10-wide.  Although the bids and offers that far away aren't as important to the current market, by glancing at the entire book from time to time, you will be able to tell where the institutions are.  When you see 50-lots (and up) in the book, it can be assumed those are the institutions (or large traders).  And every trader wants to know what those players are up to.              

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About Jack Broz
Jack Broz is a member of the CBOT and an independent analyst of  U.S. equity and interest rate markets. He can be reached through his website at www.themarlinletter.com, where he publishes his analysis daily.

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The information in this commentary is provided from sources believed to be reliable, but the Chicago Board of Trade does not guarantee its completeness or accuracy. The opinions expressed within the commentary may change without notice. The commentary was prepared for general circulation and does not have regard for the particular circumstances or needs of any specific person who may read it. Neither the information nor any opinion expressed in the Commentary constitutes a solicitation for the purchase or sale of any futures or options contracts.