Front Running or Fading Absorption ? Dom Trading Setup That Works

Published on: March 07, 2022

A long time ago (OK, 2010), the DOM and Order Flow were barely discussed in trading. Most platforms had a DOM, but they were featureless skeletal creatures with very little meat on them. Educators like John Grady at NO BS were amongst a handful of players that took a lead in teaching people the DOM, and we played our own part starting 2012 bringing in features that made reading the DOM more accessible to those of us with Goldfish-like memories.

As Order Flow became more popular, we saw more and more players gravitating towards DOM trading – some with cool and innovative takes on it, some with more questionable techniques. In this article, we’ll do a quick sanity-check, so we understand what works and what doesn’t – at least conceptually. 

Front Running
Front Running is one example of the “curse of the new DOM Trader” – which often involves throwing everything you know about trading away and looking to trade a “1 rule trading system“. That’s our name for any approach to trading that is based on a single rule. 

So what is front-running? Can you make it work?

In this image, we can see a large bid where the red arrow is at 4553.00.  Front running would involve placing an order at 4553.25.  The theory is that if this order is real, it’ll hold the market and so if you place an order in front of it – you’ll benefit from them holding the market.

So, there’s your 1 rule – “if you see a really big order, place an order 1 price in front of it”.

And this is very nice of the trader with the big order – putting it there so we can see it and get a better price than them.

Lovely!

Only 1 minor issue – it doesn’t work.  BUT it would be great if it did. No need to learn how the markets work, no need to understand what hits the market, no need to hone your skills, no need to know if the market is in a trend or a range. Just 1 rule. 

A monkey could do it. 

Thankfully, trading isn’t that simple. If it was, everyone could do it, and we’d have nobody to lose when we won. But it doesn’t mean this 1 rule can’t be a part of a more nuanced trading strategy, so let’s consider some other things we could consider:

• Only take the trade when markets are slow and lazy, lacking overall direction. 
• Look for the orders at 4553.25 and 4553.50 to increase as we move to the price – others front running the order is a good sign.
• Do not take the trade if orders disappear as we get close to that price. Note – you might want to put in your order early for queue position but pull it if they pull.
• Don’t take the trade in the first 30 minutes, or close to a news release.
• Consider taking the trade after 4553.00 holds
• Consider taking the trade only if the 156 orders at 4553 get traded and increase as people trade into it (iceberg order). 

We are now considering what that large order may represent and looking for clues to confirm or reject our hypothesis. Like many trades – sometimes it will be clear, and sometimes it won’t. Take any setup and sometimes it will be a slam-dunk, while other it’ll be a little murky.  The more frequently you take this trade, the better you will get at it. This trade will be different in thinner markets too – as it’s more common to jump to the order, trade it, hit the next price and then reverse. So, we’d go through 4553, trading the full 156, then hit 4552.75 before moving back up. 

You should not be put off by this nuanced approach. It’s what separates the men from the boys in trading. This nuance is really what trading is all about – seeing patterns and exploiting them – but patterns don’t have to be “charts” or “shapes” like head and shoulders.  In trading, a pattern would be better described as a “sequence of events” that recurs frequently. 

Fading Absorption

Front running isn’t the only “1 rule trading system” either – another popular one is “fading absorption” – absorption is when a lot of orders hit a price but can’t make headway. So buying that can’t move price up or selling that can’t move price down. It’s often the end of a move. But absorption can happen in the middle of a move as well.  On it’s own, absorption is not enough – but if you combine it, it can be a significant part of the story/sequence of events:

• A – The white horizontal line is an area of exceptionally large offers that have been there a while – we don’t want to front run them just because they are  there.
• B – The market spikes up – you can see that long green bar as we head into the level with large offers.
• C – The “balls” – these 3 over layered “balls” (for want of a better word) are mostly blue. These appear when a lot of volume appears at a level, the size shows relative volume (bigger = more volume) and the color signifies side (blue for buying, red for selling) – so we see a lot of trades, mostly buy side initiating and the price is not moving their way. The buying is being absorbed.

Now – these 3 things didn’t all occur at the same time. We saw the large offers for over 15 minutes, the spike up took a very short time (less than 10 seconds) – and the massive size that traded there was done in about 20 seconds. The large offers gave us a heads-up. The spike up and the absorption completed the sequence of events.  

Is that a guaranteed trade? Absolutely not. Is the risk small? Absolutely. This is either the end of the move or it isn’t.  You don’t need to give it a chance to go far past the blue balls. Now – would you take the trade if employment numbers were due out in 2 minutes? No – that’s another part of the story that’s playing out – but in the absence of news, it is a very interesting sequence. 

And the sequence is key. One event alone – it’s attractive but not realistic. A sequence of events – this is what the good traders are looking for. Note also – the sequence doesn’t stop once you get into the market.

But that’s for another article. 

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Order Flow itself is simply information. Just like charts, it can be used in a number of ways, some good and some bad. But let's first break down order flow into it's components so we all agree what we are talking about:

Order Executions/Tape Reading - This aspect is the real flow of orders. It's the information we see in Time & Sales, Footprint Charts, Cumulative Delta. It is looking at market orders, either as they execute or historically. I guess this is the "true order flow". Every trade is a buy and a sell. We look at market orders because we consider them to be more aggressive. When someone trades with a market orders, they are giving up a price to get an instant fill. Limit orders on the other hand just lazily sit there waiting for a market order to hit them. Often these are market makers with no directional conviction. So we see market orders as being more significant.

But we don't use these in isolation.

Volume Profile/Positions - The tape reading part helps us assess various things like momentum, traders getting stuck, balance of trade BUT the volume profile helps us understand where people are positioned and likely to get stopped out. I sometimes call this "Order Flew". It's important to know when trades will be "washed out" - for example - if we have a volume cluster on the S&P500 Futures and the market moves up 100 points and back down to it, it's unlikely short term traders on either side that were positioned there will still be there. But recent, nearby volume helps us assess areas of positions.

Market Depth - The bids and offers, the lazy passive orders waiting to be hit. This is part of the story but in terms of overall importance, I'd put it at around 20% at most. For example - if you return to the high of the day on any market, the offers will be quite large directly above the high. It means nothing at all. It's just a quirk of the market. It does not help you tell if a price will hold. On the other hand, if you see large depth and as we approach it, we see more added to the depth in front of that price, it means others are front running that depth and that is a useful bit of information.

This is the key - it is all just information. Just like price charts are information. When people look at Order Flow, they consider it to be a technique more than a set of information. They look for things like iceberg orders and decide to make a one rule trading system to fade every iceberg, For these people - yes, order flow trading is overrated because they are trying to ignore everything else going on in the markets and construct a trading system a chimp could execute.

For those looking to improve a decent trading approach, the best thing to focus on in Order Flow is momentum. Once you can read momentum you can:

• Avoid getting into positions when momentum is against you.
• Confirm trades are working after entry when momentum goes your way.
• Exit trades in profit when momentum fades.

That's perhaps the easiest way to use order flow because momentum is easier to read. It's about the market continuing to do what it's already doing. On the other hand, reading a turn in the market with order flow takes a higher level of skill and a little longer to learn.

Order flow can't put lipstick on a pig. It won't help you 'improve' something that doesn't work anyway, which is why whenever someone calls me, the first thing I ask is what they are currently doing and we discuss whether they need a reset or whether it will actually help.

When Jigsaw started back in 2011 - we were one of the first in the space and certainly had the best education. It was always going to attract the underbelly of the trading education/tools world and now we see stuff out there that is so complex but so impressive and futuristic that new traders are drawn to it like moths to a flame.

So here's my advice when looking at Order Flow

• Order Flow can't improve something that doesn't work.
• Order Flow can be used on it's own, without charts to enter and exit the market but you also have to be able to recognize different market states that need different/altered setups. There is nothing magical about this.
• Don't start jumping at shadows and take 50 trades an hour in your first week looking at Order Flow, be selective. It can be exciting to see cause and effect play out in front of you for the first time but don't overtrade.
• Do drills to learn how to read it before you trade it.
• Markets can only go up and down. Don't overcomplicate it. If you have too many Order Flow tools on your screen - you will not be able to make consistent decisions. Less is more.
• Take time to choose a market with a pace you like. Interest rates might send you to sleep, the DAX might give you a heart attack.

It is hard to see how a set of information could be overrated. It is true that some methods of presenting this information are better than others. It is also true that some people simply get on better with different tools (e.g. Footprint vs DOM).

There's a middle ground between complexity and simplicity that will leave you making consistent decisions where you improve over time. For those people, Order Flow will be way underrated because they will be the one's getting the most out of it.

Those that jump in with both feet on day one and those that have 100 different tools up, for those, it's a painful experience.

Keep it simple and manageable. Start with momentum reading and build from there. You will never look back.