Summary:
- In the context of technical analysis for stock and forex trading, order blocks refer to price levels where central banks and other financial institutions have clusters of orders. That cluster of orders creates an area of strong supply and demand which can act as a barrier to further price movement.
- Traders often use order blocks as one element of their trading strategy and may use those price levels as entry and exit points for trades. They also help traders understand the market structure and context and give them reference areas for placing stop loss and take profit orders.
- In the context of ICT (Inner Circle Trader) concepts, order blocks have a specific definition related to that trading methodology.
Introduction to Order Blocks
Order blocks (also known as supply and demand zones) are a type of support and resistance level in financial markets. They are significant price levels on a chart where institutional traders, such as big banks and hedge funds, enter or exit positions. These large clusters of buy and sell limit orders create temporary imbalances between supply and demand.
Order blocks often serve as support or resistance areas and can provide valuable insights into future price movements. Because prices have a harder time getting through these areas of strong support and resistance, many traders use these large blocks of orders to place stop losses; they assume breaks of these price levels will indicate their trade idea is not playing out as expected. By understanding blocks of orders and incorporating them into your trading strategy, you can improve your edge and trading results.
Example of a Bullish Order Block
Let’s assume that a large bank such as JP Morgan needs to exchange 10 million dollars for euros in the currency market. If they try to execute that huge order all at once at market prices they would have a liquidity problem because there may not be enough buy orders to match their 10 million dollars of sell orders. Their very large order could create sudden price moves, significant volatility, and poor pricing for the bank. Therefore, they have to divide their order up into smaller more manageable blocks, and they may need to sell those dollars over a period of time, which could be hours or days.
The process of large institutions slowly establishing or exiting long or short positions is called accumulation and distribution. On a chart, this looks like a trading range or consolidation zone, and all the trading activity will create a high-volume node on a volume profile. Most of the volume in the market comes from these large financial institutions. They are always looking to buy and sell at favorable prices, and any moves out of consolidation areas require their participation. Retail traders do not cause successful breakouts; they can only follow the big players.
Once the big banks have established their long positions in Euros, they want the price of Euros to go higher so they may start buying more aggressively with market orders causing other major financial institutions as well as retail forex traders to start buying as well, and the result is a breakout of the trading range. After a successful breakout, market participants will see the large block of orders as an area of fair value and will look to buy pullbacks to that price level. The demand from the buy orders should prevent the market price from falling below the order block area.
Identifying Order Blocks
Now that we understand what an order block is, let’s explore techniques for identifying them on your price charts. Here are a few methods commonly used by experienced traders:
- Volume Profile: The volume profile indicator displays the volume traded at different price levels. When institutions buy or sell they generate a lot of volume, and these high-volume price levels are known as ‘high-volume nodes’. They will appear as peaks in the volume profile indicator. The price that did the most volume is called the ‘point-of-control’ and will often be denoted on the indicator with a thick line.
- Price Action / Candlesticks: Candlestick patterns can provide clues about the presence of order blocks. Look for strong rejections or consolidation patterns around specific price levels, suggesting the presence of significant buying or selling pressure. Also, the beginning of strong moves is the result of institutional buying and selling, therefore those prices may be points of institutional interest in the future.
- Level II Data: Level II data, also known as market depth, provides real-time information about the bid and ask prices and the number of buyers and sellers at different price levels (Access to this data often requires a subscription service). Observing the concentration of buyers or sellers at specific levels can help identify potential order blocks. The problem with using Level II data is that institutions are known to ‘spoof’ their orders. i.e. they put in large limit orders to try to manipulate other market players, but then they quickly cancel them before they get filled. For that reason, many traders find level II data to be unreliable.
Chart Examples
In these two examples, you can see the order blocks highlighted by the gray boxes. Strong initiative buying is caused by large banks and institutions. The start of the move is a price level where the large players thought it was a good place to buy, so you can expect they may try to buy at that price again which would make it a support level.
The first example shows a daily price chart of Google (GOOG), and there is a volume-profile indicator on the right side of the chart. A long period of consolidation was followed by a strong breakout and a bullish market with higher highs. A bullish order block (gray box) coincides with the trading range, the volume bulge on the volume indicator, and the point-of-control (highest volume price) on the chart. After a strong breakout, you would expect prices would have a hard time getting through this price level, therefore so this block order would be a good place to have a buy order waiting to add to your position.
The second example shows two bearish order blocks on the Us Dollar / Swiss Franc currency pair. The first order block becomes clear after the strong bear breakout. But the more interesting example is the smaller bearish block later in the trend. After a brief consolidation, the market breaks lower and then pulls back to the order block before continuing lower. Traders could have placed a sell short trade using a limit order at that bearish order block with a stop just above. It would have created a low-risk entry in a bear trend, and after prices quickly moved lower, the foreign exchange traders could have exited for a substantial profit relative to their risk.
Trading Strategies with Order Blocks
Recognizing order blocks is just the first step; applying effective trading strategies is crucial for success in the Forex market. Here, we present two popular strategies that traders often utilize when trading with order blocks:
1. Reversals
Many traders have trade setups that require reversal patterns at higher time frame support and resistance areas (such as order blocks). These types of trades usually have a low probability, but often have small risk and large reward potential.
2. Breakouts
A breakout strategy involves identifying manipulation zones within order blocks and taking advantage of the subsequent price momentum. Once the price breaks out of the consolidation range, traders can initiate positions in the direction of the breakout. Proper risk management, such as placing stop-loss orders and setting profit targets, is essential when implementing this strategy.
3. Pullbacks
The pullback strategy is a higher-probability trade setup that focuses on entering during price retracements after a breakout or strong momentum move. Traders wait for the price to retest the breakout level or the accumulation zone before entering positions. This strategy allows traders to potentially get better entry prices and reduces the risk of entering positions during false breakouts.
ICT (Inner Circle Trader) Order Blocks
Some traders follow a methodology called ICT (Inner Circle Trader), which has many of its own unique terms such as fair value gaps and liquidity voids. Within that methodology, an order block has a specific definition that is similar but more specific than the generally used term. See our article on ICT order blocks.
Conclusion
In conclusion, understanding order blocks and incorporating them into your trading strategy can provide you with a competitive advantage in the Forex market. By recognizing the accumulation and distribtion zones, identifying potential trading opportunities, and implementing effective trading strategies, you can navigate the market with confidence and potentially achieve your trading goals. Stay informed, adapt to market conditions, and continue honing your skills to excel in the dynamic world of Forex trading.
Risk Disclaimer: Trading in the financial markets involves risks, and it’s important to conduct thorough research, seek professional advice, have a trading plan, and trade responsibly. The information provided in this article is for educational purposes only and should not be considered as financial advice. Remember to assess your risk tolerance and only trade with funds in your trading account you can afford to lose.