Trade by the Book – A Guide to Reading Order Flow

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 seeSimulated 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; theChange 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 downso 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 atwww.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.

Here are 2 more good articles:

http://www.cbot.com/cbot/pub/cont_detail/0,3206,1070+15731,00.html
http://www.cbot.com/cbot/pub/cont_detail/0,3206,1070+15731,00.html