An order imbalance occurs when there are not enough buy or sell orders on the market to meet the demand for the opposite order type.
Order Imbalances in the Market
Order imbalances usually occur as a result of the release of important information, which drastically alters the market’s perception of a security and leads to a significant shift in the equilibrium price of the security.
As the price of the security moves from its old equilibrium level to its new one, order imbalances can occur that effectively stop trading in that security for their duration.
Order imbalances in large volume securities can last minutes, while order imbalances in small volume securities can last for one or more trading sessions.
Order imbalances are cleared when the price changes enough that previously reluctant buyers or sellers are now willing to trade at the new price or when market makers bring reserve securities into the market to add liquidity.
Persistent order imbalances may lead to an official halt in trading, which is usually triggered by the price of the security changing more than a set limit within a specified time period, which will differ across exchanges and asset classes.
Order Imbalances and Trading
Order imbalances represent the kind of trading opportunity that day traders are well-positioned to exploit.
Order imbalances often lead to panic buying and selling, where traders are willing to weather dramatic price shifts to enter or exit a position. This means that order imbalances are often followed by sharp corrections back toward the old price equilibrium point as the market finds its new long run equilibrium price level.
Order imbalances can also have a negative impact on a day trader’s position when they are unable to close out a winning trade as a result of a lack of counter-party.
While a day trader may experience an extremely profitable trade on paper, they are unable to close the position at the optimal price due to a lack of counter-parties willing to trade at this price.
Order imbalances and similar market phenomena are why it is so important for day traders to use limit and stop orders, and other advanced order types, instead of market orders for most or all of their trades.
A market order will seek out the earliest counter-party at any price, which may be benign during normal trading yet harmful during extreme market events, such as an order imbalance.
Limit and stop orders, as well as more advanced forms of these order types, will ensure that a trade is only executed under the most favorable conditions to the day trader.
Order imbalances represent the kind of market phenomena that can lead to significant gains or losses for day traders. The lack of willing counter-parties in an order imbalance means that the price of the affected security can swing wildly in the span of minutes or even seconds.
Not only should day traders be able to recognize the signs of a potential order imbalance, but they should always structure their trades to protect themselves from unexpected order imbalances and similar extreme market phenomena.