Forex Market Microstructure – Analysis of Order Patterns and Price Discovery.

Forex market microstructure – Forex market microstructure is the very basis of the forex market. It is the market mechanisms that determine the price, the reasons behind spreads and quotes, trade volume and volatility and its workings.

It’s of paramount importance to traders and investors to know market microstructure to accurately predict market price movements and identify high potential trading opportunities.

Price Discovery

Finding prices on foreign exchange is a messy business for both informed and uneducated customers. Be knowledgeable, and your private data might influence dealer price you receive, but which is not added to the total market price because of interdealer trade – inefficiency is the root cause of some of the older exchange rate conundrums.

In this article, we explore how noise from microstructure affects volatility persistence and price discovery in an exchange (forex) market and how they relate to covariance matrices of market-wide prices.

This article shows us from high frequency data, that the quality of the forex markets have not improved in the recent years. Moreover, liquidity replenishment after macroeconomic data announcements have declined. Time series fluctuations in information proxies and quote counts were only weakly related to price discovery, and changes in trader numbers were both negative and positive effects on liquidity recovery.

Order Flow

Order flow is a day-by-day report card of the market in which the buyers and sellers balance each other over time. Trading orders can be more transparent, so traders are better equipped to spot market changes and exploit them; if there are more orders in place for buying or selling, it’s likely that there is more demand or supply that may impact price; if there aren’t many orders, then customers might be indecisive or lack of interest.

By performing order flow analysis traders can locate support or resistance levels. A pile up of buy orders at one timeframe might serve as resistance and a bundle of sell orders might serve as support. Furthermore, the traders can watch the delta order flow charts to look for any divergence with price which might indicate trend shift.

Order flow is based on liquidity, which determines how fast transactions can be made and how much prices adjust with changing market conditions. You need to understand how liquidity works and order flow for traders to make as much profit as possible, and to receive as much return as possible.

Market Liquidity

Market microstructure includes the complexity of the trading systems at different exchanges and knowing these details is important when designing profitable trading algorithms.

Forex (Foreign Exchange Market) is a changing market in which trader buys and sells currencies based on their current forecast of future price, which may be affected by the development of the economy or monetary policy of a country that determines the value of the currency.

: Government institutions routinely publish macroeconomic indicators that could impact the forex market. This paper analyses high-frequency EBS data to understand its quality change post- announcements; in particular, it finds that price discovery has increased and liquidity recovery has decreased since the macro announcements – which matches theory of quote submission growth after macro announcements, which leads dealers and high-frequency traders to act like blind traders.

Volatility

Market microstructure is the inner dynamics of financial markets like price formation and what causes the price action. This basis allows traders to use the tools of technical analysis more precisely.

The research on market microstructure has produced empirically sound models, but also leaves deep unsolved questions such as what private information is, and how it affects transaction costs and price discovery. Markets grow fast, and a better sense of their microstructure has never been more crucial.

Traders and investors will need to understand how their strategies will be affected by the changing nature of this market and especially by the development of trading algorithms as more than 10% of all trading volume is generated by algorithms. Some funds now have an in-house market microstructure analyst who is responsible for all of the elements of a dynamic marketplace, and analyzing trade data to identify trends or patterns in trade behaviour.