In A look back on my journey – Part 6 – Volume Profiling I talked about the volume profile and how that gives me potential areas to put on trades.  The next question is how to confirm & time an entry.  I want to start off by saying that I’m convinced me that the market is a lot more random than we may think.  We can come up with support & resistance levels and either they hold or they don’t.  Can we “confirm” an entry if the output of the trade is random?

Everyone is talking about order flow and it’s the new buzz word.  I have to admit when I created this blog 5 months ago I was caught up by the order flow craze and I was determined to learn what it is and how to use it.  And so I named this blog “Trade with the Flow”, as in “order flow”.

I’m no expert on order flow, I’m just learning it myself.  A lot of people talk about tape reading and how the legendary traders such as Jesse Livermore & Richard Wyckoff could trade by reading the ticker tape.  A lot has changed since then as we now have real time volume for each trade and we have the ability to know if each trade was on the bid or the offer.

I started learning order flow with the volume ladder (also known as volume footprint by Market Delta but I think they trademark that name so I prefer to call it the volume ladder).  To me the ladder is just a way to organize time & sales to make it more readable.  Here’s an example:

One idea for trading with the volume ladder is this:  When there are a bunch of longs at the top of a bar and they can’t take price higher, then if price drops a few ticks lower then these longs must stop out which will push the move down even farther.  And the opposite for the shorts.  And that’s how I use the volume ladder in a nutshell.

The challenge is this pattern occurs all the time and then “disappears” as longs continue buying and push price higher.  Another challenge is you have to be very quick to recognize it.  I think it’s a really cool way to see what’s going on at each price but honestly I have trouble making money with it.  Sometimes a bar will reverse without this pattern.  Sometimes this pattern won’t result in a reversal.  Sometimes the pattern will fail 3-4 times in a row and then catch the top.  In short, it’s a tool that takes lots of practice.  And even after spending most of 2010 using it, my view is that it can help to time entries but context is much more important.  And if you have the right context, entries become a lot less important.

Now I should talk about delta because “delta” is whether the order was on the bid or the offer.  I don’t want to go into detail about all this because Market Delta’s website has lots of free videos and webinars on the subject.  But I will say I find the delta concept can be misleading at times.  Pros can use a combination of limit and market orders and the delta will only show the market orders.  This makes the traders using limit orders invisible.  So in other words, the orange box at the top of the ladder chart shows longs entering on market orders.  But they were selling into someone wanting to go short.  So we can count the volume as “buying” volume but does that tell us what’s really going on?  And sometimes when the bid/ask moves around, the delta can be completely wrong.  I’ve compared delta with different datafeeds and it’s always conflicting.  In any case delta tracks the traders using market orders and the traders using market orders are not always right.  So next the challenge becomes how to know which side is “right”?

Before answering that, if you total up all the shorts on a bar and all the longs, you can then subtract the shorts from the longs and come up with a total, and this is the “delta” that people refer too.  But as I said, it’s not completely accurate.  Sometimes the bar will go up with positive delta and sometimes the bar will go down with positive delta.  So it’s not simple.  Some traders accumulate the delta, others look for divergences, and others apply momentum calculations to it (“delta momentum”).  But as I said, if the concept has issues to begin with, then all these derivatives of delta are going to have issues as well.  Here’s an example of delta shown as candlesticks:

I do have delta on my charts and the main way I use it is this:  If I see a lot of buying yet price doesn’t go higher, then that’s not bullish.  One doesn’t need delta for this, the VSA folks have been doing this for a long time now.  If you have a high volume up bar but it closes well off the high, you can assume that a lot of that volume was selling which pushed it back down off the high.  So it’s the same concept really, just different ways of looking at it.

The other way I use delta is when i enter a position, say long, the only way price will move up is if other longs enter behind me.  So if I see delta increasing then that tells me longs are entering.  But if longs are entering then price will be going up too and it’s easier to just watch price.  For example a bunch of longs could enter giving a positive delta but maybe price doesn’t move?  Which should I believe?  Unfortunately there’s no simple answer to that.

In the chart above I marked a bar with a very high delta.  There was a lot of buying there and the market only went up 3 ticks (it’s a 3 tick renko chart).  Does that mean price is going to reverse?  No.  It means at those current prices there were a lot of sellers.  If those sellers stop out, that could push price up.  If those sellers keep selling and/or if no more longs join the move, then price will reverse.  So one has to be analyzing what’s going on at every price in order to anticipate moves.

Which leads me to my favorite tool for reading order flow – The DOM.  This is more appropriate for scalping and for timing entries with precision, such as when using tight stops.  It takes a long time to learn and I’m just getting started so I’m not qualified to write much about it.  I’ve asked a lot of traders about it, hoping to learn the secret to reading the DOM.  Everyone has said basically the same thing:  There are no secrets.  It’s an art more than it is a science, and it takes a long time to learn.  By long time I mean watching only the DOM for a few months. Very few people have the patience and discipline to do this.  I sure didn’t a year ago, but I do now.

I hope to write more about the DOM in the future but I want to stress that unless you’re scalping I really don’t think it’s necessary.  I know a trader who enters only with limit orders and he’s very profitable.  This shows how context is much more important than an entry.  It can go against him a few points he doesn’t mind because he is right the majority of the time.  He may be able to time the entry better with the DOM, but then he wouldn’t be able to trade multiple markets as easily.  And many times I try to time my entry only to find out that I just made it worse.

My goal for this page, like this series, is not to teach (a task for which I am not qualified) but rather to share a few ideas & experiences, and to tell you what I’m currently doing.  I must admit I haven’t fully worked out how I use order flow, but my current focus is the DOM.

Next I’ll discuss how to put everything I’ve talked about together.

Continued in A look back on my journey – Part 9 – Conclusion