Within the current forex market environment, there exists two kinds of brokerages – Market makers and Electronic Communications Network ECN brokers. Since the forex markets is primarily unregulated, there exists no central center for forex trading. The ECN system was implemented to provide traders with immediate access to the forex market, allowing them to match themselves with other traders, and conduct transactions.
When a trader is looking to buy or sell currency, they are required to submit an order that mentions the price at which they are willing to buy or sell, and the required volume of currency. When another trader finds the order suitable, a trade can be initiated.
What is order flow trading?
Before one can begin to understand how the Electronic Communications Network uses the order flow mechanism, it is first important to know what kinds of transactions the mechanism is used for. Order flow is used between traders looking to perform directional trades. A directional trade is one where a trader assumes that a particular currency price is either going to move up or down. If a currency is anticipated to move up, a buy order is issued. Conversely, if a currency is expected to go down, a sell order can be submitted.
Order flow, also known as transaction flow can take place when a trader believes that the price of a particular currency is going to change and accordingly places a transaction to be executed. Traders who look to adopt aggressive strategies within the market are likely to place market orders.
A market order will require traders to pay the difference between the available buying price and the selling price. However, if traders are not seeking aggressive strategies, they also have the option of executing a limit order. A limit order, also termed a stop order, allows the trader to define the price at which a transaction must be executed. Both forms of trading fall under the banner of order flow trading.
Market orders are generally placed by traders who want quick results and are not prepared to wait for other traders. Limit orders require other traders within the market to find a trader’s deal acceptable before execution. If there are no traders willing to complete the deal, then the limit order will become void. Nevertheless, even if a limit order is not executed, it still does influence the overall order flow within the market.
What is market depth?
When brokers trade via the Electronic Communications Network, they are provided access to important information relating to the volumes of transactions being traded within the forex market. The market depth is defined as the volume of currency available for transaction at a particular point in time in the forex market. Using the ECN, brokers will be able to gauge the best possible ‘Ask’ and ‘Bid’ prices, relevant to their limit orders.
The market depth will list all the various orders that traders are willing to execute on the forex market. When a limit order is matched with another, a trade will be executed and the two limit orders will be removed from the market depth list. The executed transaction will then be recorded in the forex market’s trade history.
The importance of order flow trading
Prices of a currency do not move based simply on technical indicators or moving averages. If a currency price is to move, a limit order must be matched with another. When enough limit orders are executed, the currency price will move on the price chart to reflect these transactions.
As such, understanding order flow trading is about anticipating the manner in which other traders in the market are behaving, and placing yourself in an advantageous position accordingly. Order flow trading is less about numbers and figures than it is about predicting the behavior of other traders within the market, by thoroughly analyzing the various scenarios, prevailing mentalities and expectations within the market.
While technical analysis may move the price of a currency in some cases, the reality is that it cannot take into account whether the appropriate limit orders will be available for a trade to executed. Using technical analysis may lead to losses because limit orders may expire or be triggered before the market moves in your favor.