Being still a beginner to trading, I’m currently studying through the book “Order Flow Trading for Fun and Profit” and am, at the moment, facing a difficulty with not fully understanding a few bits and pieces about price change as the result of the consumption of liquidity and also stop hunting.
Therefore, if you’re an experienced or pro trader who’s very familiar with the order flow trading and the above mentioned
subjects, I’d really appreciate if you could PM me so that I could ask you a few very specific questions on these topics.
As the introduction to what I need help with, here I’m going to share with you three paragraphs from the above mentioned book’s chapter “The Role of Stops” that I hope you could help me fully understand and master.
Paragraph #1: Price Change as the result of the Consumption of Liquidity (in the form of pending limit orders and stop losses)
Frank is a trader who decides to place a market buy order containing 75 contracts in the situation where there’s an exchange rate of 1,000 (Ask) / 0.999 (Bid) of an imaginary currency pair. Immediately after Frank’s market buy order has been executed, it automatically consumes all the available liquidity in the form of pending limit orders placed between 1,000 and 1,008. As a result, the consumption of this liquidity left a large gap between these two price levels.
Now imagine that many traders have identified 1,007 as a significant resistance level. Also, let’s assume that there’re ten contracts worth of stop loss orders sitting at 1,008.
Once Frank’s market buy order gets executed 1,008 automatically becomes the market ask rate. This is important for you to know because the stops placed at 1,008 are set to execute when the market ask rate hits that price. Once the stops are triggered, they become market orders and begin consuming any available liquidity until they are filled.
Now, let’s pretend that Frank knows there’re ten stops sitting at 1,008. Knowing this, Frank decides to place a limit sell at 1,008 for five contracts.
Here’s where it starts to get interesting (and also complicated enough for me as a newbie trader).
After Frank’s market buy order has been completed, he would have an average entry price of 1,0035 on his 75 contracts. Now, by placing a limit sell at 1,008 for five contracts, he manages to book 4.5 pips of profit on each of those five contracts. When you figure in the profits that he’s already booked, the net cost of his position is reduced to 1,00325.
My question #1: How exactly can I get or calculate 1,00325 that’s the reduced net cost of Frank’s position?
Paragraph #2: Stop Hunting
What Frank has accomplished in the previous example is what order flow traders refer to as “stop hunting.”
Next I’m going to share with you an example of how large speculators look for every opportunity they can get and stop hunting is a reliable way to generate profits.
For instance, imagine a market that’s biased lower. The “biased lower” jargon here means that the latent demand curve is disproportionally skewed toward a downward move in current value (or current price). In this type of environment, large traders, who usually have a good pulse for such biases, will see a short position as a valuable asset to have. However, acquiring that position is going to generate a great deal more slippage on entry than an equally sized position would if the market was in equilibrium, as the bid sizes are going to be relatively small. This is obviously a problem, but imagine there’re a huge number of stops sitting at 1,005. To keep the example simple, let’s pretend there’re 60 contracts worth of stops.
In the above scenario, a large trader can exploit the stop placement to accumulate a large position at an advantaged price, without causing any slippage.
Now, let’s imagine a situation where a large trader who’s name is Jane places a 50 contract limit sell order at 1,005. For your information, there’s a total of 25 contracts worth of limit sell orders between the current price at 1,0005 and the stops sitting at 1,005. To make it more understandable, let’s have Jane execute a 25 contract market buy order in order to consume them. As a result, Jane’s market order eats up all the available liquidity between 1,000 and 1,005.
For your additional information, there’s a total of 54 limit sell contracts at 1,005, so with 60 stop contracts firing off when the ask hits that price, we can assume that price will continue on up to 1,007. We can also assume that all of Jane’s order would be filled in the process.
Now, let’s see what Jane’s position looks like. The average entry price on the 25 market buy order contracts was 1,00208. When all those contracts were liquidated at 1,005, Jane managed to pocket 2,92 pips on each of them. BUT, Jane’s limit sell order was for 50 contracts, so after her long position was liquidated, she started accumulating a net short position. Since the stops were large enough for her to fill the remainder of her order, we know that she accumulated a 25 contract short position at 1,005. After accounting for the profits that she’s already booked, she is left with an average entry price of 1,00708. Not only is that a very nice position, but it’s also noticeable that it was accumulated without ANY slippage.
Here’s a series of my questions related to Paragraph #2: Stop Hunting:
Question #1: How exactly can I get 1,00208 that’s the average entry price of Jane’s 25 contract market buy order?
Question #2: What exactly is Jane’s net short position? Is it 50 contracts of her limit sell order? If not, what is it?
Question #3: I don’t really understand what it really means when, in the above paragraph, it says “….she accumulated a 25 contract short position at 1,005.” What’s confusing here for me is that the author mentions that she accumulates a 25 contract short position at 1,005 while there’re altogether 50 contracts of her limit sell order at 1,005.
Question #4: How exactly do I get 1,00708 that’s Jane’s new average entry price after accounting for the profits that she’s already booked?
Question #5: How would you explain the reason why Jane is now in a very nice position?
Question #6: How can I know, for sure, that there isn’t ANY slippage at the end of Jane’s entire order’s execution (liquidation)?
Paragraph #3: Conclusion on the Relationship between Price Change and the Liquidity Distribution
Now, it’s going to get a whole lot better for Jane. As we’ve learned earlier, a move like this leaves a gap in the liquidity distribution and when the latent demand that was sitting between 1,001 and 1,005 hits the market, we should see price slingshot back towards the downside. In addition, remember that the liquidity distribution was already skewing to the downside. That means the conversion of latent demand is going to have an even larger impact on price. The end result is that, after a minute or two, current value (current price) actually drops BELOW the original starting price.
Now all Jane has to do is to let the weight of the latent demand interest drive price lower. Eventually, it will reach a new equilibrium level. When it does, she can run a stop hunt in the opposite direction to close the position slippage free.
Question #1: Could you, please, explain to me why exactly the whole situation is going to get a lot better for Jane, because I don’t really understand why?
Question #2: Does the latent demand between 1,001 and 1,005 represent potential buyers or potential sellers?
Question #3: How and when the latent demand between 1,001 and 1,005 could potentially hit the market? Is it when traders who place market sell orders that the price from above 1,005 starts dropping down so that it, on its way back down, starts meeting this latent demand?
But again, I don’t really understand what the whole latent demand interest is all about. So, could you, please, explain to me in plain English what exactly is going on in here (referring to both Question #2 and Question #3)?
Question #4: Could you explain to me how exactly a new equilibrium level is created when price starts dropping back down?
Question #5: What are the exact benefits for Jane to run a stop hunt in the opposite direction, because as a newbie trader I don’t really understand the actual reason for it?
And, here’s my very final question for you: “In your own words, how would you explain why exactly traders use stop loss orders apart from just protecting themselves from losses?”
In advance thank you ENDLESSLY for all your kind assistance and support that really mean the world to me at this critical turning point in my life where I’m striving to reach my desired financial freedom.