The Origin of OFA, Part 2
If you have read The Origin of OFA post, you now have insight into how Order Flow Analytics™ came to be. Now, let’s look at why the software was developed in the first place.
People have been trading for centuries, each limited only by the amount of information available to them. Hundreds of years ago, traders watched ships from docks as they approached their port hoping to gain profitable trading insight. Twentieth century technological advancements enabled traders to shift from hand-plotting charts derived from newspaper data and ticker tapes to computerized visualizations of market activity.
During the 1980s (when software charting became prevalent) and 1990s (before anyone had access to intraday time horizons), though it was a phenomenal leap forward, the computer revolution forced one very serious limitation on prospective traders.
Instead of receiving a ticker tape of every trade like the “bucket shop” speculators of the early 20th century, slow Internet speeds forced data services to chop up the trade information into pre-configured time segments. This resulted in generations of trading strategies based on 5, 10 and 30-minute snapshots of market data being thrust into the public domain, while the art of analyzing the ebb and flow of the tape all but vanished from modern trading.
For years “pit traders” were able to thrive by following the market auction process while standard operating procedure for software vendors remained focused only on the open, high, low and close (OHLC) price data. Well, as of July 5th, 2015, almost all the pits are closed as the shift to exclusive electronic trading moves forward. Sadly, 99% of the tools available to retail traders still take an antiquated OHLC approach to market analysis.
But OFA pioneer D.B. Vaello had a different pursuit when it came to market data. He wanted to see which side of the trades were being struck on the tape. Are trades being triggered by the sellers or the buyers? There is an important distinction between buying into the offer and selling into the bid. This distinction can only be detected by observing the market auction.
Keep in mind that there are only two ways a trade can happen at every market auction:
Either a buyer moves to accept a seller’s offer or a seller moves to accept a buyer’s bid.
Trades will be either struck into the bid or into the offer; consequently, price movement flows in the desired direction of the buyers or the sellers. Price doesn’t move without enough conviction by one side or the other.
The financial market auction is the mechanism that represents the intentions of buyers and sellers. What is each side trying to accomplish? How committed are buyers to moving price higher? When will sellers relent and allow buyers to do so? Or will sellers be successful in moving prices lower? Market auction data reveals the volume of orders flowing in from buyers and sellers, which can then indicate the level of conviction to move price that each side has at a specific point in time at specific price levels.
This information gives a trader an indication of how the market feels about current price levels. Market sentiment cannot clearly be determined with the use of a stationary price indicator; it is best revealed through order flow analysis.
If one side has sufficient conviction and is able to move price then a market bias appears and a trend may develop. Alternatively, if one side is showing conviction but cannot move price then the other side is likely to assemble greater conviction and take prices in the opposite direction. The beauty of order flow analysis is that it reveals market conviction prior to price movement.
In addition to analyzing order flow to confirm market moves, there is another important component for order flow traders to follow: volume at price. Traditionally, traders have used time-based aggregations of volume to identify active instruments (liquid markets). But typical volume histograms tell nothing about where volume is being traded. Wouldn’t it be more effective to use the volume of trades struck at each price level to make trade decisions? The truth is volume at price rendered through a volume profile tells you much more about current market sentiment.
Either buyers or sellers will often be in control, and volume will rise and retreat as price moves through different price levels. Some participants will trade at a certain price level and others who will prefer to hold on to inventory until price moves in an anticipated direction. A volume profile is used to identify areas that traders see as fair value and will therefore look to trade at those levels.
OFA has been built on these concepts because D.B. recognized the importance of enabling retail traders to identify how and where volume is entering the market. He realized that institutional traders use order flow to make their trade decisions and felt, with the same information displayed in an organized way, he can trade like the pros and improve the trading success for others as well.
Want to learn more about the market auction? Click here for further reading.