I frequently use the term “context” in my instructional material. There is a reason for this. Context is the key to understanding why certain trades have a better than 50/50 chance of being profitable. If you do not understand context, you will most likely not develop a consistently profitable methodology. If you’ve gone through some of my course material, you will be familiar with this idea but a review never hurts. I will break this down as best I can in a blog post.
When I am giving a short presentation or posting a YouTube video, I always try to convey the importance of context but it can be difficult to fully explain because the viewers are not seeing the full day’s activity nor are they viewing it from the perspective of an experienced trader who has seen many different types of market conditions over a period of decades. Many young traders have never seen the volatility we’ve seen in the last year. They didn’t even know such a thing could exist. In fact, a 1,000 point rally in the Dow the day after Christmas is unprecedented. No one has ever seen that till now. This is why there is no substitute for experience.
When students sit with me in the webinars, they are able to gain a true understanding of context and appreciation for it. The differences in price action become very clear. They see how trading directly after a number release is quite different from trading when there is no news. They see how even though a lot of volume may be trading and it may look busy and enticing, the action is unreadable. They see how the markets can sometimes go from dead to volatile to dead again in just a few minutes and if you don’t react during the volatile period, you miss the opportunity, maybe for the entire day.
The conditions obviously play a role in the method. The markets do have to move in order to make money. Volatility is a necessity. But sometimes the volatility can be too wild. Sometimes the slower movement is easier to read. Sometimes the action is too slow and it’s impossible to call the next move. So a person has to learn how to read the context correctly.
When a person first looks at a depth of market platform (DOM) and sees all of the rapidly blinking numbers, he does not understand how watching that can be helpful. The bids and offers are frequently changing and the prints sometimes happen so fast that the human eye cannot follow them. The person is looking at the DOM and none of the activity is making sense. There are two major reasons for this.
1. The person does not even understand what an order book is. He doesn’t realize the entire market is nothing more than an auction.
2. He doesn’t understand context and the bigger picture.
The order book is just that. It’s a book of orders. There are resting bids and offers at multiple prices. These are orders from people who are willing to buy and sell a certain amount at certain prices. The first question one should ask is, “Who is placing these orders? Because it’s not me.” Think about it. You turn on your screen in the morning, boot the DOM and take a look. There are bids and offers ten prices deep. It’s as though they just magically appear every day. Someone is currently willing to buy at a price of 9 and someone else is currently willing to sell at a price of 10. There are more bids at 8, 7, 6 and lower. There are more offers at 11, 12, 13 and higher.
Why are those bids and offers there? Who is willing to trade at these prices right now? What reason would an individual have for placing a bid at this price in the ES at 8:45am Eastern when he or she hasn’t even seen the 9:30am stock market opening action? Why is a person suddenly willing to buy 4000 contracts in the 10-year Treasury notes when hardly anything has traded for the last ten minutes?
An order flow trader isn’t trying to keep track of every contract traded at every price. It’s not just about whether 50 traded here and 20 there and 200 here and so on and so forth. We’re looking at the total amounts trading and keeping track of how those transactions are currently affecting movement.
Let’s say the average retail ES trader decides he wants to buy at a price of 2550.00. He wants to buy because the market has been moving lower for the last couple hours and he thinks 2550.00 will be the point where it stops and reverses. The first problem with this line of thought is he comes to this conclusion without having any verifying information. He could at least wait to see if buy orders step up there and try to hold or if the market blasts right through it. But he’s not thinking that way because he’s never looked at an order book. So he places his order, gets his fill and waits.
Professional’s question: “For what are you waiting?”
Trader’s answer: “Price to go higher, of course.”
Professional’s question: “How does that happen?”
Trader’s answer: “…what do you mean? It just does.”
It’s as though he doesn’t realize his one lot means absolutely nothing in the grand scheme and in order for him to get paid, thousands of contracts will have to move through the offers and other traders will have to bid at higher prices. Or…the bids do not come and instead the market continues collapsing as offers overwhelm bids and he loses when his randomly placed stop-loss is hit.
In order to anticipate the most likely direction, you must try to understand how the professionals and institutions operate. They are the ones who may buy and sell fifty times during a ten point run in one direction or they may buy and sell fifty times in a range bound area. But they are the ones who are actually moving price. Much of what they do is dependent upon what is happening in the order book. And the smaller orders from HFT programs and retail traders who understand order flow are all responding to the movement being created by the professionals and institutions. Hence the reason the number of contracts available and the number of contracts trading are so important to the big picture.
Now…let’s look at context.
The ES moves a few points higher off the open but then stops and holds around an area where a lot of volume is trading. Every time it touches the day’s high, it drops lower but only by a couple points. Orders are trading and buyers continue to try pressing highs but not enough bids are there to do the job and create a breakout to new highs. The pace of the activity is slow, meaning you do not see it rapidly jumping back and forth seven or eight ticks in the blink of an eye. It’s just kind of moving tick to tick every few seconds, back and forth with no visible pressure in either direction.
In this scenario, trades become more of a coin flip. You can see that the highs are holding and this may make you think about a short trade. However, it’s not falling lower easily. It’s just hovering in an area a few points from the highs.
Since it’s not falling lower easily and just hovering below highs, you may think about a long trade. However, buyers have not been able to push to new highs in the last ten minutes even though they’ve tried multiple times and there is currently no buying pressure at the highs.
How do you anticipate the most likely move in this situation? Can you really make a high probability/low risk read here? Is there any information at all which gives you a clue? Realistically, can you honestly say you have a reason for thinking the next few thousand contracts that trade will be in this direction or that direction?
Right from the opening bell, the ES starts collapsing. It is rapidly moving towards yesterday’s low. Every time some buy orders hit the offers and pop the price higher by a tick or two, sell orders immediately come in and knock it back down five or six ticks and then keep pressing lower. What’s the thought process here? Are there likely to be sell-stop orders at yesterday’s low? Probably. There will most likely be sell orders from traders looking to short the breakout through the low as well as sell orders from long trades covering their positions at a loss if the technical support is broken. It’s a prime area for a domino effect of sell orders triggering other sell orders. It’s a place where a short-term feeding frenzy to the downside could take place. It’s not a guarantee but look at it from a statistical perspective.
It’s a fast market moving in one direction. People will be paying attention to yesterday’s low. Sell stops will probably be triggered there. A short-term wave is likely. Whatever the case, a long trade is bad idea;) It’s either short or flat. This makes sense. You have a reason for your call. Experience tells you that you will most likely see a lot more contracts hitting bids in this area.
This is the reason some trades are not coin flips.
Traders are constantly looking for reasons to be involved. They need to look for reasons to not be involved. If you look at a situation and can’t find any reason to not be in the trade, chances are it’s a great trade. If you look at a situation and can immediately tell yourself three reasons to not be in it, then it’s probably not a good trade.
Incidentally, the reason traders are constantly looking for reasons to be involved is because it’s not natural to sit and do nothing for hours on end. Good trading goes against our biology. If we are awake, we want to be doing something constructive. We want to be expending our energy in a creative way. Looking at it from a business standpoint, if we’re putting in the time, we want to be getting paid. So the thought of sitting for five hours and not making any money isn’t pleasant. Therefore, we search for reasons to be active and involved. But making money as a trader requires you to do a lot of nothing most of the time.
The treasury markets are far more liquid than the stock indexes and this can be both a pro and a con. The pro is that there are times when the information in the order book is extremely helpful. The bids and asks make a lot more difference from tick to tick. The con is that they are sometimes so thick they barely move.
There are times when the number of contracts trading at one price does act as a trigger for a trade. There are other times when the same number of contract trading is irrelevant.
The 10-year note futures are plowing higher through offers and 6,000 contracts trade at the high of the day. 6,000 contracts on the offer is a lot of contracts and sometimes it is enough to stop a move higher but on this day, the buyers don’t seem to care. They buy right through the 6,000 and keep bidding, now hitting new highs. The market is busy and the major players are clearly making moves. That type of heavy volume trading during a momentum push is good. It can be an indication that there are real players interested in continuing to press higher. Going with the momentum and playing a long side breakout could be a solid high probability trade. At the very least, there’s no point in taking a short trade till the momentum shows some sign of slowing. This makes logical sense.
Over the course of the morning, the 10-year note futures have stayed in a very tight range and when they moved, the movement was quite slow. They have barely moved for the last fifteen minutes. Suddenly 8,000 contracts trade on the offer followed by 6,000 trading on the bid. It’s activity. A lot of contracts just traded. But look at it within the bigger picture. What’s happening?
This is where new students don’t see the context. They think something must be happening and a move must be coming because why else would 14,000 contracts suddenly trade? Well, there could be several reasons but the most likely reason is that a large spread order was just executed in order to offset risk on a cash position. What does that mean? It means an institution executed a trade in the cash market and then hedged the position in the futures market. It’s also possible the traders on the other side of that trade quickly made a few more trades to hedge themselves, take a quick 1 tick loss or possibly double down and try to hold the market at those prices. But whatever the situation, it’s highly unlikely the market is now going to quickly move eight ticks in one direction. Those types of orders are usually “one and done” orders, meaning it was something that needed to be done in the moment and there is no intention of trading another 14,000 contracts anytime soon. One can reach that conclusion if one understands the treasury markets and context.
This makes a massive difference in the bottom line over time. Being able to distinguish “good action” from “bad action” is one of the main talents of profitable traders. It’s how they find high probability trades and eliminate coin flip trades along with trades which are almost certain losers (doubling down and/or averaging in as the market continues to punish you and destroy your account). I cannot stress this enough.
Always be thinking about context. Think about who is playing. Think about the normal behavior of the market you are trading. Think about the likely scenario based on the given information. You want to watch the DOM and take note of the prints, bids and asks, and volume profile but you also need to see the bigger picture. When playing chess, one has to look at the entire board and not just the last two moves made by your opponent.