A simple lesson in supply and demand can help ensure your trades are executed
An unchangeable rule of stock trading is that every buyer has to have a seller. An order imbalance occurs when there are not enough orders on both sides of a stock transaction.
In this article, we will review the role of supply and demand in stock trading. We’ll also explain why the concept of liquidity is so important. We’ll go over how the market lets investors identify market imbalances. And we’ll provide tips that can help you develop a trading strategy to help profit from an order imbalance.
The Immutable Role of Supply and Demand
The most common way that a stock price is set is through an auction process. Buyers and sellers place bids (for buying) and offers (for selling). When the bid and ask prices match, a trade is made.
This illustrates the immutable role that supply and demand play in the stock market. Every stock trade must have a buyer and a seller. If there are more buyers than sellers, which is known as an order imbalance on the buy side, the stock price will go up. And if there are more sellers than buyers, known as an order imbalance on the sell side, the price will go down.
This dynamic also creates the environment for an order imbalance. A bid price is the price that someone is willing to pay for a stock. The ask, or offer, price is the price at which the seller is willing to sell the stock. When there are more traders looking to buy then are looking to sell, the sellers will ask for higher prices for their shares causing the stock price to go up.
Conversely, when there are more sellers than buyers, sellers may accept lower offers for their shares, and/or buyers will lower their bids.
Is a Buy-Side Imbalance Good or Bad?
A buy-side imbalance indicates strong demand to buy a stock. And this is a bullish indicator. However, investors have to be careful not to get caught up in the “irrational exuberance” that can come from chasing a rising stock price. If a trader is looking to buy a stock at $125 and there is an imbalance of orders on the buy side, they may have to make a higher bid price to execute a trade or wait until a market order comes in to clear the logjam.
Is There an Order Imbalance Indicator?
There is, but first, it should be noted that order imbalances can occur at any time. If the order imbalance exists before the start of trading, it may be necessary to delay trading on those individual stocks.
However, on every full trading day, starting at 3:00 p.m. the New York Stock Exchange (NYSE) posts order imbalance data. This is literally a list of the order imbalances that will have to be cleared at the closing auction. Traders who trade on order flow may use this data to set up a trade that puts them on the right side of this imbalance.
The Role of Liquidity in Order Imbalances
Ideally, electronic trading means that willing buyers can be matched up with willing sellers more efficiently than humans could. However, it doesn’t change the fact that stock trading operates as an auction system. This is where the concept of liquidity comes in.
As it pertains to stocks, liquidity is a measure of how easy it is to trade a stock. Ideally, you’ll want to trade a stock with high liquidity. Liquidity is one of the key metrics used by active traders because it ensures there are plenty of buyers and sellers for a stock. This doesn’t mean there will never be an order imbalance but it does help ensure that trades can be executed.
In fact, if an order imbalance occurs during a trading day, there are market specialists that may distribute shares from a reserve and issue market orders to provide the needed liquidity. However, if the imbalance becomes too unmanageable, trading on that stock may have to be suspended until the imbalance is corrected.
How to Create an Order Imbalance Trading Strategy
Stock traders can profit from order imbalances by executing an order flow trading strategy. This is a very sophisticated type of trading that’s best left to traders who have the time and the resources to execute trades.
Order flow is a straightforward term referring to the mechanism that moves stock prices up and down. Most trading software programs will allow traders to view the Depth of Market ladders (also referred to as the Price Ladder Display).
The middle column of the ladder shows various stock prices. The left column is known as the Bid side. This indicates the number of limit orders for contracts at that price point or better (meaning lower). The right column is the Ask side. This indicates the number of limit orders for contracts at that price point or better (meaning higher).
Because electronic trades are filled, frequently in milliseconds, these windows are very dynamic. That’s why order flow trading is very complex. Just looking at order flows only gives you information that has already happened.
That’s why if investors trading on order flow will want to have access to footprints software that allows them to quickly analyze where order imbalances may exist. While this still relies on speculation, it can allow traders to make a more educated guess. But in reality, most investors will find that there is very little profit to made in attempting something that is basically attempting to conduct arbitrage on statistical anomalies.
Some Final Thoughts on Order Imbalances
Many traders don’t give a second thought to order imbalances. And the reality is these order imbalances are frequently cleared up with little or no disruption to actual trading. Traders that want to profit from an order imbalance trading strategy will almost always use one or more of their own favorite indicators to set up their trades.
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