Market Microstructure

Behind the ‘veil’ of Price | Indicators that signal market microstructure dynamics | Part 4 of 4

In the first three parts of this series we looked at indicators which give us a sense of the microstructure activity of an instrument. In this last and final part, we will try to put it all in context.

Lets’ start with the first principles, the key to all that we are discussing is to see - if LOB (Limit Order Book)/Microstructure dynamics leads price change? If so, is the lead time ‘tradable’. What I mean here is, if it leads by a fraction of a second, then it’s not easy to trade on that signal, we need a lead time within which we can execute a trade.

Another way of articulating the first principle is - What moves price esp. Index Futures? What is the direction of causality as the academicians would say? Does spot/cash market lead futures or is it the other way round?

The reason it’s important to get a handle on this is, because the tools that one would design or use would need to be completely different.

For instance if the Index Futures lead price discovery, then it makes good sense to use Orderbook/Microstructure information as that would ideally precede the move in price. However, if it’s the spot or the cash market that leads, then you may want to look at indicators that capture the bias within the index constituents.

 If you look at the academic literature that examines lead-lag relationships between index futures and spot, you would find indexes which fall on either ends of the spectrum in terms of their bias, almost all would be bidirectional at some points. It seems the degree of participation from Individual Investors, Domestic Institutional Investors and Foreign Institutional Investors has an effect. I am sure there are many other structural reasons which influence this lead-lag effect.

Evidence for NIFTY suggests a Spot to Futures direction of causality.


Now that we have some sense of the direction of causality, I leave it to you figure out, which indicators (in a shorter time frame) would better predict NIFTY Futures. It’s also worth exploring if this lead time between the Spot and futures market is “tradable”.

Behind the ‘veil’ of Price | Indicators that signal market microstructure dynamics | Part 3 of 4

Part 1

Part 2

In this part we will explore the third indicator that I use which helps us in understanding the dynamics that happens in the Limit order-book before large moves, in a way this is one those “predictive” indicators as it signals oncoming volatility a few minutes before it actually does – The Average Bid-Ask Spread.

In the slack room, I call it SOS – No not “Save our Ship” but “Spikes on Spread” – Which indeed is an SOS signal if you have any positions on, as it signals one to be alert.

Before we get to the mechanics of this indicator, one needs to have a basic understanding of how the Limit Order book (LOB) works.

So if you look at the L2 market depth, this is how it would typically look at a given moment (Graphically i.e.)


Now let’s see what happens when a Market Order hits the book. In this example a Market Buy Order hits the book.

The contracts marked in Yellow are the one which are consumed by the Market Order. Now do compare the spread in the two illustrations. In the first one we have a spread of 1 and in the second, because of the market order coming in the spreads doubles to 2. Now let’s see what happens next.

As you can see in the above illustration, the limit orders (Bids) come in to fill the spread. This Expansion-Contraction of spread due to market orders coming in can happen and can be observed over different timeframes. But the concept remains the same.

Microstructure academicians also call this the Liquidity Cycle or more specifically the Make – Take Phases

Typically you have shorter “Take Phases” and longer “Make Phases”, which fits in with the fact that we would typically have lesser market orders compared to limit orders.

With theory covered now let’s move to practice.

Look at the NIFTY Futures 1 minute time frame chart (Date – 8th May’18)

On the top pane is NIFTY Futures Price, the second pane has Average Bid-ask spread as a Histogram aggregated for each minute. On the Second pane is a 5 minute (Orange) over 45 minute (Grey) SMA of the Spread, the last pane has Volume rate which we’ve looked at already in part 1 of this series.

If you notice the spread for NIFTY Futures oscillates in a range of 0 to 2.

So how do we use this indicator?

Observe the spread from 12:05 to 12:45 – If you see the price has largely been range bound but the spread moved from the upper band to the lower band – Remember the concept of “Take Phase”?

My conjecture is this is a period where liquidity takers are sort of sweeping the book, the price remains range bound up till the point where adequate liquidity exists, the moment there is an imbalance we see large moves or volatility come in, and as these initial bursts come in, perhaps herd and threshold behaviour takes over causing extensions of these moves.

Since this indicator is like an oscillator with a fairly defined range – it’s easy to spot deviations and be prepared for an upcoming move, however one must remember this indicator does not predict direction all that it does it predict volatility.

As of now I am still testing and collecting data to do back-tests on this indicator, so I do not have any statistics to support my claim, but people in the slack group know – how often I call out an ‘SOS’ and how accurate or inaccurate it turns out to be.

The usual disclaimer applies to this indicator as well – this indicator  is to be used within the context of the market structure and in combination with other indicators discussed in this series.

Update - Another screen shot of NIFTY FUT 10th of May'18

Behind the ‘veil’ of Price | Indicators that signal market microstructure dynamics | Part 2 of 4

Previous part here 

In this part we will explore the second indicator that I use which helps us in understanding the dynamics which happens as price action unfolds, i.e. points where price turns, also known as "Imbalances". Adam Grimes in his book "The Art and Science of Technical Analysis" says something interesting about Imbalances.


Imbalances happen in the Limit Order book (LOB), however in the absence of LOB info. we can use executed order info. as a proxy to access LOB imbalances. The indicator known as “Volume Delta” tries to do just that. It looks at volumes executed at ask vs. volumes executed at bid to make an assessment of an imbalance.

Delta here is defined as - The net difference between the buying and selling (volume) at each price (footprint delta), each bar (bar delta), or the entire day (cumulative delta).

All that you need to know about delta is here - and it makes no sense to reinvent the wheel, what I think is of more value to the readers here is to know how to use it in the context of NIFTY.

Delta becomes important only at points where there is a divergence, meaning price moving in one direction but delta getting skewed in the opposite direction or in other words – More aggressive buying as the price goes down and more aggressive selling as the price moves up  Such divergences point to a possible change in trend or a reversal.

Now it’s important to understand that this indicator measures divergence caused by aggressive buying or selling i.e. through Market Orders, but in reality passive limit orders could also cause both reversals and continuations and in NIFTY the ratio of market orders to limit orders would be close to 30:70, so one has to factor that in.

At this point I want to categorically say that as far as I know there is no programmatic way of determining if an execution is a market, limit, or a stop order. So the idea that attributes “aggressiveness” to market order driven (long/short) at that price point is not correct, it could always be stop’s being hit as well, or for all you know it can also be marketable limit order. This is the reason why divergences per-se can be both a point of reversal or continuation.

Let’s look at the following chart.

In the image above – The Red colored candles mean (Greater than “x” size volume at Ask compared to Bid) and the Green candles mean (Greater than “x” size volume at Bid compared to Ask) in that specific bar. X can be set to a User defined value or you could ignore it totally and let the indicator point you to every imbalance that occurs. This is an illustration of "Per Bar Delta" which is what I use.

As you can notice there are some divergence signals which act as points of continuation and some act as point of reversal, meaning some Red markers which don’t lead to a fall instead cause further up-move and some green candles which don’t lead to a raise but instead cause a further fall.

I repeat this, because a lot of novices buy into the fact that this (Indicator ie not the idea of Imbalance) is some sort of a holy grail and all that they need to do is follow the divergence signals and buy or sell accordingly, twitter traders and indicator sellers don’t make life any easy either.

That’s the reason we really need to use this indicator within the probabilistic context of the market structure of a given product.

There is another nuance in terms of the input factor for this indicator usually Volume Delta Indicators come with two modes of inputs – Up/Down Tick and Bid/Ask, choosing either of these can also alter the output.

At the end, like all other indicators this is no holy grail stuff, however can be an extremely useful reference if you can combine it with market statistics and other indicators referenced in this series.

Behind the ‘Veil’ of Price | Indicators that signal market-microstructure dynamics | Part 1 of 4

As most of you in the slack group know, this year my focus is on finding indicators which would help us get better, more refined entries and exits in our existing setups.

And I was sure that these indicators either have to be some sort of visualization of the Limit Order Book (LOB) activity or at least must signal the change in state of the book, even if it takes inputs from executed orders.

In this post we will look at the concept of Trade Rate/Pace of Tape/Trade Intensity  - these are conceptually the same. Essentially we are looking at the time taken for the price to move from 1 tick to another or volume acceleration in a given time.

Let me tell you how I landed on this idea – After having watched the market depth (L2) for years, I knew for sure that the beginning and the end of a micro-trend usually happens with a flurry of orders and then the pace comes down and the price retraces a bit or coils around for a while. Being a visual person, I wanted to chart it and that’s where my search for such an indicator began.

I did find several mentions of it for different platforms but didn’t find one for NT8.

To read more about it, some good soul has collated all the information here

Similar Indicator for a Different Platform

I later found this one

Since it had a selection for both Volume and Trade rate I thought it would be better to play around with. So I got this one coded for NT8

Now let's see how to use this indicator. If you have read the links above you would have guessed by now that this indicator is used mainly to identify the location of a trend or micro-trend change. As always it cannot be used in isolation and without relevant context of the market structure.

Now let’s look at a an example from NIFTY Futures

Look at the areas marked with a rectangle, what you see in the above chart is Price (100 Tick)/Volume Rate/Trade Rate (Green Line Chart)

You will notice that trend reversals coincide with the Trade rate being in the upper band. You will also notice that it coincides with the spikes on the Volume Rate. More importantly one needs to observe what I call the “Trade Rate Cycle” and look at turning points in the Trade Rate, which is easy to identify as it operates within a range/band.

Again, this is no holy grail, but at least offers information that is behind the veil of price.

 Note – I am still testing this and would in future do some back-tests as well.