How to Perform Order Flow Analysis in Forex

In trading, understanding the mechanics behind market movements is crucial. This article delves into the concept of order flow analysis, focusing on its unique challenges in the decentralised forex market, and offers alternative strategies rooted in supply and demand dynamics.

Order Flow Analysis and Its Limitations in Forex

Order flow analysis serves as a powerful lens through which traders examine the buying and selling activity in a market. In conventional markets like stocks or commodities, it involves scrutinising various data points sourced from a centralised exchange, such as bid-ask spreads, volume, and types of orders, to gauge the market’s direction.

Performing order flow analysis in the Nifty 50, S&P 500, FTSE 100, and other indexes is commonly employed by trading professionals. However, when venturing into the forex market, the decentralised structure poses a significant challenge to traditional order flow analysis. Unlike centralised markets, forex lacks a single point of record for all trades, making it difficult to gain a comprehensive picture of market activity.

The absence of centralised exchange data means traders can’t easily access the complete order book, which contains essential details about pending buy and sell orders. Consequently, conventional methods of order flow analysis become far less straightforward, compelling traders to adapt and look for alternative approaches tailored to the unique intricacies of the forex market.

The topics discussed here are relatively complex. For the best understanding, head over to FXOpen’s free TickTrader platform to apply what you’ve learned in real-time.

Supply and Demand Imbalances

One piece of the puzzle is in imbalances. Supply and demand imbalances occur in areas where either demand significantly exceeds supply, causing a sharp price increase, or where supply overwhelms demand, leading to a steep price drop.

In both scenarios, these imbalances often manifest as distinctive candlestick patterns on a price chart. They may appear as engulfing candles, where the body of the candle “engulfs” the previous one, or as surging candles that showcase a dramatic price change within a short time frame.

Unlike standard market moves that often see a retracement or pullback shortly after, these imbalances typically lead to sustained directional price movement. They are easily identifiable with the naked eye and play into the following aspects.

Auction Market Theory

Auction Market Theory (AMT) complements the concept of supply and demand imbalances by providing a framework to understand how these imbalances arise and evolve. AMT posits that financial markets are like auctions, constantly seeking a level where a transaction can occur between willing buyers and sellers. When the market discovers a value area—where most transactions occur—it tends to stay within that range until an imbalance forces it out.

This is where AMT and supply and demand imbalances intersect. When an imbalance occurs, AMT helps identify these zones as areas of transition between buyers and sellers. For instance, a sharp price increase due to overwhelming demand signals a shift in the value area upwards. However, it also leaves behind a value area that typically sees price revisits in the future.

Supply and Demand Zones

Supply and demand zones serve as the “footprints” left behind by the significant imbalances that occur in the market. These zones are ranges of price levels where the market previously witnessed overwhelming buying or selling activity, which created the imbalances in the first place.

AMT helps us understand these zones as crucial transition points. When a supply and demand imbalance occurs and forces the market out of its current value area, the levels at which this change occurs become the new supply or demand zones. In essence, these zones represent price ranges that the market is likely to revisit. They can be traded through, but, more often than not, they prompt a reversal in the current price movement.

Generally speaking, a supply/demand zone precedes a sharp move up or down. For a supply or demand zone to be valid, it should be untested, i.e., the price shouldn’t have revisited the area, as in the chart. It’s also worth noting that multiple supply zones can be present within the same value area.

Market Structure

The market structure serves as the overarching framework within which supply and demand imbalances, as well as Auction Market Theory, operate. The structure can be uptrending, downtrending, or range-bound. In an uptrend, for example, a series of higher highs and higher lows are established.

According to the principles already discussed, the most recent higher low often coincides with a strong demand zone. Traders anticipate that this level should not be broken; if it is, the trend may be shifting to a bearish phase, although not always. The opposite is true in a bearish trend.

It’s important to note that there are two types of structure: overall structure and candlestick structure. Overall structure governs the broader moves (blue line), while candlestick structure refers to the highs and lows made by the candles within the overall structure (black line). Generally, the overall structure has a greater chance of holding, while the candlestick structure often switches back and forth.

Putting It All Together

Navigating the unique challenges of the forex market requires a holistic approach. Traders can integrate the concepts discussed here to gain actionable insights into technical analysis and order flow.

Starting with market structure, traders first evaluate the directional bias—be it uptrending, downtrending, or range-bound. Key highs and lows (i.e. overall structure) that align with the prevailing trend are marked, as these are levels that are likely to hold. Next, traders turn their attention to identifying significant imbalances where supply massively outweighs demand or vice versa, causing substantial price moves.

AMT helps traders pinpoint the range that existed before these large moves, regarded as an area of fair value that is likely to be retested. Within these ranges, supply and demand zones offer precise levels where price reverses, usually continuing the existing trend. This integrated approach offers traders a robust methodology for making sense of forex market complexities.

The Bottom Line

In comparing order flow vs technical analysis, there’s no doubt that order flow provides much more insight into why markets move the way they do, rather than simply predicting future direction. It’s also timeframe agnostic; long-term order flow analysis over many months and years tends to hold up just as well as short-term analysis despite the large discrepancy in timeframes.  

While this article has offered a tailored approach to the forex market, the same principles work across the stock, commodities, and crypto markets*. To access hundreds of these markets and the advanced TickTrader platform where these images were created, consider opening an FXOpen account.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.