Order Flow

Charts are a pictorial representation of the price of a financial security over a period of time. That's it.

They don't predict the future, they're a tool.

We use charts to help us find attractive risk/reward opportunities.

We use charts to help us get on the right side of the order flow.

What is order flow?

Order flow is the net buying or selling pressure on a security (stock/ETF). In other words, who has control, the buyer or seller, on the time frame you are trading on?

Our goal is to get on the right side of the order flow. That sounds obvious but is different than people think.

Getting on the right side of the order flow has nothing to do with how well you analyze a business.

First example: Apple's stock

Apple weekly chart

In the above example, buyers could not maintain control above $130, despite great news for the company. They were hitting it out of the park, they could do no wrong.

Over the next year, the stock fell more than 30%.

However,

Sellers could not maintain control below $92, despite the bad news.

During this time many analysts "thought" Apple's best days were behind them...

They thought Samsung would displace Apple by offering a lower priced phone.

Using the chart above, we determined the risk/reward favored being long as long as the $92 level held; despite other investors believing the future outlook was bleak.

In other words, order flow went from offer to bid below the $92 level. Sellers could not maintain control below $92.

Sear this into your brain—In order for your investments to profit, other investors have to agree with you, eventually...

It is their orders that will push your investment to either a profit or loss. 

Example 2: Tesla's stock

Tesla weekly chart

Tesla went public in 2010 and traded in a narrow $20-$40 range for three years. On April 1st, 2013, the buyers took control from the sellers above $40.

Once above $40, price exploded. The stock rallied ~650% in a little over a year, perplexing most people along the way.

How did this happen?

You'd be hard-pressed to find the bull case for Tesla in 2013 from analysts or hedge funds. Most were short and not buying their story.

The arguments against Tesla were: Nobody will buy expensive electric cars, how can they compete with GM and Ford, look how much money they are losing, etc...

In hindsight, some arguments were right and some were wrong. Does it matter? Nope, because if you were short, you lost.

That's why order flow matters.

The short interest in 2013 was 45%; meaning, of the stock available to trade, 45% had been borrowed and sold.

Once the stock broke-out above $40, shorts started to cover (buy back shares).

In addition,

Other investors decided to short, adding further fuel for the rally because they "thought" the rally wasn't justified by the fundamentals.

Investing in public equities is like poker, to succeed in poker, you play the man, not the hand.

Are you saying fundamentals don't matter?

No, they are important. To gain an edge you need to focus your research on two things:

1. The current expectations embedded in prices. This is the market's perception of the future (i.e., what they think the fundamentals will be).

2. What will actually happen in each business. The future reality.

Often, 1 & 2 align. Alpha is when they don't. (h/t Patrick O'Shaughnessy/@patrick_oshag)

Since estimating the future is hard, we use order flow and charts as clues. Many times, price moves before the fundamentals are obvious.

To achieve superior investment results

You have to have a better-than-average ability to figure out when risk-taking will lead to gain and when it will end in loss.

There is no alternative.

-Howard Marks

As an example, let's walk through a trade we took in October 2017

On May 24, 2016, Barron's published this piece about Twitter.

As luck would have it, Twitter bottomed on that exact day at $13.73.

Since then, Twitter has gained almost 250% over a two-year period.

On October 30, 2017, we issued a trade alert to our members.

(click chart to enlarge)

We bought Twitter for $21.73 (orange arrow). Since then, we have taken profit on half our position for a 100% gain in less than a year.

Why did you decide to buy then?

We bought because the buyers gained control from sellers above $20.

Take a look at the 4 short red arrows on the chart. Those represent times where the sellers maintained control below $20. In other words, every time price approached or briefly traded above $20, the buyers could not maintain control above that level.

Until the week of October 30th. The buyers finally maintained control above $20.

That's why we bought. Something changed from the previous 4 times that caused the buyers to lose control above $20.

In addition, the upside (price appreciation) justified the downside (our stop) so that if we were right, we'd get a nice payout.

Buzzfeed top ticked Twitter

Buzzfeed top ticked twitter (1)

On June, 21st, 2018, BuzzFeed posted the article above.

From the article:

"But then, even as those eulogies were being published, things started changing. Twitter began beating earnings expectations. Star ex-employees trickled back in, finding a new, more positive internal culture than the toxic one they’d left. Advertisers came back too, as did users. The company finally began addressing its trolling problem. And its stock, once unappealing to analysts like Nathanson at $14, is now trading above $46."

While the street was crushing the stock, the "fundamentals" were changing behind the scenes.

Barron's bearish article was published the exact day Twitter bottomed.

This one was close. It was published six days after the stock hit multi-year highs at $47.80.

What's the point?

When the fundamentals become obvious, like stories about their turnaround being reported, the best time to buy has passed.

The skill is knowing when to put money risk in situations like Twitter and when not to.

Some companies don't turnaround.

Friendster (a social network displaced by Facebook) went to zero...

Final thought

Our focus is getting on the right side of the order flow, regardless of the fundamentals.