First, let us examine some general characteristics of the data. It captures all trades transacted on FXCM occurring in 2017, time stamped in milliseconds, and with their trade prices and signed trade sizes. The sign of a trade is positive if it is the result of a buy market order, and negative if it is the result of a sell. If we take the absolute value of these trade sizes and sum them over hourly intervals, we obtain the usual hourly volumes (click to enlarge) aggregated over the 1 year data set:

It is not surprising that the highest volume occurs between 16:00-17:00 London time, as 16:00 is when the benchmark rate (the "fix") is determined. The secondary peak at 9:00-10:00 is of course the start of the business day in London.

Next, I compute the daily total order flow of EURUSD (with the end of day at New York's midnight), and I establish a histogram of the last 20 days' daily order flow. I then determine the average next-day return of each daily order flow quintile. (I.e. I bin a next-day return based on which quintile the prior day's order flow fell into, and then take the average of the returns in each bin.) The result is satisfying:

(One may be tempted to also regress future returns against past order flows, but the result is statistically insignificant. Apparently only the top and bottom quintiles of order flow are predictive. This situation is actually quite common in finance, which is why linear regression isn't used more often in trading strategies.)

Finally, one more sanity check before backtesting. I want to see if the buy trades (trades resulting from buy market orders) are filled above the bid price, and the sell trades are filled below the ask price. Here is the plot for one day (times are in New York):

We can see that by and large, the relationship between trade and quote prices is satisfied. We can't really expect that this relationship holds 100%, due to rare occasions that the quote has moved in the sub-millisecond after the trade occurred and the change is reported as synchronous with the trade, or when there is a delay in the reporting of either a trade or a quote change.

So now we are ready to construct a simple trading strategy that uses order flow as a predictor. We can simply buy EURUSD at the end of day when the daily flow is in the top quintile among its last 20 days' values, and hold for one day, and short it when it is in the bottom quintile. Since our daily flow was measured at midnight New York time, we also define the end of day at that time. (Similar results are obtained if we use London or Zurich's midnight, which suggests we can stagger our positions.) In my backtest, I have subtracted 0.20 bps commissions (based on Interactive Brokers), and I assume I buy at the ask and sell at the bid using market orders. The equity curve is shown below:

The CAGR is 13.7%, with a Sharpe ratio of 1.6. Not bad for a single factor model!

*Acknowledgement*: I thank Zachary David for his review and comments on an earlier draft of this post, and of course FXCM for providing their data for this research.

===

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## 32 comments:

Thanks for this Ernie, thought provoking stuff. I have always ignored volume in my systems, may have to re-visit. I wonder if the order flow system would transfer to intra-day movements? Say hourly orderflow?

David

Thanks, David. Order flow should translate to intraday return prediction, but my study of hourly flow on EURUSD didn't work.

Ernie

Interesting article, though I don't think you can draw too many conclusions on a 1 year backtest. Does the strategy hold on other FX rates?

Thanks,

Daniel

Hi Daniel,

Agreed -unfortunately there is only 1 year of data available. This also doesn't work as well for other rates.

Ernie

The average Joe can't obtain this data from an OTC broker.

Would it work using tick data of CME FX futures (classifiy-ing buys or sells by either a big data job of matching up timestamped actual trades with the just prior bid/ask ... or determining buys abd sells by the inferior, but more tractable, "bulk classification")

TC,

Yes, if you have true futures tick feed (not like the feed provided by IB which is sampled at 250ms), you can apply the tick rule to estimate order flow. If you are paying for the expensive direct MDP feed from CME, they will tell you the order flow explicitly (via the aggressor tag on each trade).

I have determined that results from bulk volume classification are inferior to a tick-by-tick computation, hence I have disavowed it.

Ernie

Thank you for the article, Dr Chan!

A quick question for you, regarding the logic as a whole, you summed all the trades into net values of volume, considering that sell trades were negative and buy trades were positive, sorted then into quintiles over a moving window of 20 trading days and then realized that there was almost a linear relationship between the top quintiles (buy skewed) and positive returns on the next trading day, and vice versa for the lowest quintile. Right?

Thanks!

Edit for typos

Hi Eduardo,

You summarized correctly!

Ernie

Tks Dr! Definitely worthy of further testing.

Thanks. It is insightful. I think only Oanda supply order flow information but it I don think it can be downloaded. Maybe retail traders have to trade manually.

Good to know about Oanda - thanks.

Ernie

By the way, FXCM told me that they can offer anyone free historical order flow data for 6 months in 2017. Just email premiumdata@fxcm.com.

Ernie

thanks for an interesting post. this seems as a strong indicator that could be turned into a high Sharpe Ratio strategy even on daily data. I think I have seen papers on predictive power of order flow

I have a suspicion though, that the proprietary order flow would correlate strongly with the buying pressure on the order book, ratio of the sums of limit sizes on the ask and bid books. That would mean it can be estimated from publicly available data.

Hi M,

Yes, order book imbalance has also been shown to be predictive of future price change.

See Cartea 2015 (the HFT book on my Recommended Books list on right sidebar).

Ernie

Hi Ernie,

I enjoyed your class you taught for MSPA. Interesting post. Quandl also apparently offers data from CLS which may be an even better indicator for volume since it takes into account large institutional trades. I don't subscribe, but the service does seem to offer volume hourly.

Brad

Hi Brad,

You are right about Quandl. The cost, however, is beyond the reach of most retail investors.

Ernie

Inform yourselves about the moral problem of trading :

https://sites.google.com/site/tradingonlineamoralproblem/

Hi Ernie,

By buying pressure I meant the sum of volume over all order book levels, or or restricted to 10 best or similar. In my experience almost as strong an indicator as order imbalance, with a bit different dynamics.

Hi M,

Presumably you are only summing all the buy orders for a buying pressure?

Ernie

Do you know if there is any sort of similar feed for CME futures data? Are there any techniques to infer buy vs sale that are reasonably accurate. Most algos I’ve seen just assume buys are at offer and sells are at the bid.

Dave,

Yes, if you subscribe to CME's MDP feed, it has an aggressor tag for each trade that enables you to compute order flow. My 3rd book talked about it.

Yes, there is also a technique called Tick Rule (based on whether it is uptick or down. Up is considered positive flow) and BVC method (complicated). All these methods are described in my 3rd book.

Ernie

What is the nature of the signal you trade in the mini S&P strategy? It's long vol it seems - how do you get that kind of profile when designing a strategy?

Thanks!

Hi,

Short term momentum strategies are typically long volatility.

Ernie

Hi Ernie

Great article. When conditioning on high past volume, are you perhaps picking up short term momentum in prices? I.e have you tried controlling for price momentum and see if the order flow effect is still there?

Thanks

Hank

Hi Hank,

Thanks.

Yours is a good question, and I have not tried to control for price momentum in this study. I do expect positive correlation between contemporaneous price return and order flow in the past period. However, from a trading perspective, those occasions when one reverts in the next period and the other doesn't that are most interesting (and profitable). The theory is that price change in the absence of strong order flow will likely mean revert (i.e. exhibit serial anticorrelation), while price change in presence of strong order will trend.

Ernie

Quick question. In previous comments you mentioned that your trading records were public at epchan.com/accounts. However I get an error accessing that. Is this no longer public?

It has been moved to www.qtscm.com/accounts.

By the way, where did you see that comment that said epchan.com/accounts - I need to correct it!

Thanks,

Ernie

Hi Erine

Do you know what is the difference between CQG API and CQG Web API (continuum Connect)?

Thanks

George

Hi,

Ever since I found that CQG is missing ticks in its historical data, I have stopped using them. So I am afraid I don't know anything about their API's.

Ernie

The regression of flows to returns was insignificant which is a huge warning sign. I think you're just picking up on the strong dollar downtrend (especially against EUR) that was persistent throughout 2017.

Yes, it is quite possibly a chance correlation in 2017, which is why we need to confirm this effect in other years pending data availability.

I don't, however, regard the lack of statistical significance in regression a major issue. Most of the time in recent years if we see significant regression for a single predictor in finance, the effect is either overfitted, or it has look-ahead bias. If life were so easy with a single factor ...

Ernie

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