Yellow Capital Blog/Crypto Market Making/Trade flow imbalance: what it is and how it impacts crypto prices

Trade flow imbalance: what it is and how it impacts crypto prices

Friday, June 21, 2024

Trade flow imbalance is a very relevant concept in financial markets, even more so in this highly volatile world of cryptocurrency trading. The understanding of trade flow imbalance is essential to extract market sentiment and potential price movements that could be conceived as part of an overall trading strategy.

What is Trade Flow Imbalance?

Trade flow imbalance refers to a situation in which the buy and sell orders for an asset become very lopsided. Simply put, it would be the mismatch between the demand—buy orders—and supply—sell orders—in the market. This could lead to substantial price movements as an effect of the market rebalancing to restore equilibrium.
Think of a seesaw. On one side, you have buy orders, and on the other, sell orders. When either side vastly outweighs the other, the seesaw tip—price change occurs. This is the essence of trade flow imbalance in action.

Why It Matters?
Therefore, for a trader and investor, monitoring trade flow imbalance is crucial, as it gives one a view of the market sentiment. A high buy-side imbalance suggests enormous demand, which may ignite some price increments. Conversely, if the sell-side imbalance is high, there will be considerable selling pressure, pushing the prices down. Understanding these dynamics can help traders make informed decisions and anticipate market movements.

Causes of Trade Flow Imbalance

Large Orders and Institutional Activity
This in turn may mean big buy or sell orders, especially from the more mature institutional traders, cause massive trade flow imbalances. For instance, the decision by a hedge fund to buy a massive amount of bitcoin can push the price sharply high if there is insufficient liquidity to fill up that similar order. By the same token, substantial sell orders can swamp the market with supply.
Market Events and News
Other things that will likely cause an imbalance in trade flow are major news stories or events in the markets. For example, good news like a well-known corporation accepting a particular cryptocurrency for payments can lead to a surge of buy orders and, thus, become a source of buy-side imbalance. Conversely, bad news, such as the partial or total closure of legislative loopholes, is likely to incite numerous sell orders and contribute to a sell-side imbalance.
A key example is the 2017 Bitcoin bull run, during which news on mainstream adoption and investments brought about huge imbalances to the buy side, driving prices to levels previously unprecedented. The 2018 market crash, on the other hand, had sell-side imbalances brought about by regulatory fears and corrections in the market.

Analyzing Market Sentiment

Social Media Sentiment
Tracking Mentions and Trends
Keeping an eye on mentions and what's currently being discussed on platforms might give you an idea of the market sentiment. A sudden spike in mentions or a trending hashtag may indicate growing interest in the specific cryptocurrency. For instance, this was very common during the 2017 ICO boom, whereby the big projects gaining traction over social media got massive price run-ups as investors rushed to buy in.

Sentiment Scores
Sentiment analysis tools usually assign sentiment scores to social media posts as positive, negative, or neutral. These scores tend to give the trader some intuition about the overall market mood. For example, when a high positive sentiment score exists about one particular cryptocurrency, that is indicative of a bullish sentiment—meaning there may be an indication that the price would go up—and, in contrast, when a high negative sentiment score exists, the indication then is bearish, signaling there may be a price drop.

Retail Trading Activity
That is because it is in high-volatility periods when retail traders driven by market sentiment and emotions create such large trade-flow imbalances. An example is during the 2021 Dogecoin rally, crowds of retail traders ran into a buying spree on Dogecoin following tons of social media hype, creating a huge buy-side imbalance. That surge sent prices to levels no one had ever imagined before a sharp correction set in.

How Trade Flow Imbalance Impacts Crypto Prices

More Volatile
This creates a massive driver of price volatility in cryptocurrency markets: imbalanced trade flows. When there is a high imbalance, the market will find it hard to absorb the excess buy or sell orders, resulting in rapid price change. For instance, in 2017, during the bull run in Bitcoin, significant imbalances in the order flow on the buy side created powerful upswings, followed by sudden drops in price whenever these imbalances are unwound.
Recall the sudden spike in price by Bitcoin in early 2021 upon news that Tesla was investing $1.5 billion in it. Such news creates a buy-side imbalance, and the price shoots up rapidly. On the other hand, when profit-taking comes, sell-side imbalances create sharp price corrections, highlighting how volatile trade flow imbalances can be.

Instances of Volatility
For example, in January 2018, Bitcoin lost more than 20% of its value within days after an unexpected statement from South Korea regarding a possible ban on cryptocurrency trading. It goes to show how news-induced imbalances might lead to extreme price volatility.
Another one was in the DeFi summer of 2020. The launch of new DeFi tokens and high buy-side imbalances was a perfect mix for fast price appreciation; however, as the hype settled and early investors started taking profits, it caused significant sell-side imbalances, which resulted in extensive price corrections.

How Trade Flow Imbalance Impacts Crypto Prices

Price Discovery

Impact on Price Discovery
Trade flow imbalances are significant for price discovery processes. Consistent trade flow imbalances can be the start of new market prices. For example, if there is a buy-side imbalance, the price will keep adjusting upwards until an equivalent supply of sell orders meets the demand force.
This has a lot to do with price discovery because, in the initial listing of a new token, the imbalance in flows from both buys and sells can be a massive factor. If opening trading sees an overwhelming balance of buy orders, the price is bound to skyrocket until sellers go to market for equilibration to demand.

Real-World Examples
But in the summer of 2020, the listings of new DeFi tokens took place, like, for example, Uniswap's UNI, and this directly gave rise to a huge amount of buy-side imbalance due to investors rushing to get in on those. That quickened the process of putting a market value on offer for these tokens, showcasing the role of trade flow imbalances in price discovery. Likewise, Bitcoin futures trading introduced in December 2017 on CME has shown a muscular trade flow imbalance initially dominated by buyers in establishing the futures price before the market became more balanced.

Crypto Market Sentiment

Reflection of Market Sentiment
Trade flow imbalances usually reflect the overall mood in the market. High trade imbalances can likely signal a bullish sentiment; correspondingly, a muscular buy-side imbalance and a high sell-side imbalance in opposite directions signal a bearish sentiment. Monitoring these imbalances can help traders anticipate future price movements. For instance, a bullish market creates buy-side imbalances as several investors rush to invest in the assets with the expectation that their prices will increase. In a bear market, on the contrary, there tend to be more sell-side imbalances as most investors exit the game to avoid further losses. ** Sentiment Ind Traders can then use this trade flow imbalance as a sentiment indicator to predict possible price trends. For example, when the buy-side imbalance is persistent, this can be a precursor to a price rally; on the contrary, the sell-side imbalance can indicate a forthcoming drop in price. It is understood that the market gets a little more transparent by tracking sentiment indicators, such as the Fear and Greed Index, against imbalances in trade flows. Quite often, during extreme greed, buy-side imbalances will be prevalent, while periods of extreme fear see sell-side imbalances.

Locating Imbalances in Trade Flow

Tools and Techniques
Order Book Analysis
Order book analysis is one of the most fundamental ways to pinpoint an imbalance in a trade flow. The trader can analyze the volume and distribution of orders between the buy and sell sides for the day or any other period to determine the current market condition. An imbalance is confirmed by the vast difference in the distribution of orders between the bid and ask sides.
For example, a trader may note that the number of large buy orders is far higher than that of sell orders at a specific price level, and thus, a buy-side imbalance prevails for those instruments. On the other hand, when the number of sell orders is high with only a few matching buy orders, it suggests a sell-side imbalance.

Volume Indicators
Volume indicators that may assist in identifying these imbalances in trading activity are the Volume Weighted Average Price (VWAP) and On-Balance Volume (OBV). Higher trading volumes on one side in imbalanced conditions can create a signal.
For instance, should there be an acute rise in the trading volume coupled with an increase in the price, the indication would be for a buy-side imbalance. At the same time, a surge in volume and a price decrease would suggest a sell-side imbalance. These indicators help traders know underlying demand and supply dynamics.

On-Chain Analytics
On-chain data provides insight into the flow of cryptocurrencies between wallets and exchanges. Examples of such tools include Glassnode and CryptoQuant, which give detailed on-chain analytics and, therefore allow a trader to spot more significant movements of funds that might point at a trading flow imbalance.
For instance, monitoring significant inflows of Bitcoin into an exchange might signal upcoming sell pressure, thus creating a sell-side imbalance.

Trading Strategies for Trade Flow Imbalances

Exploiting Imbalances

Trading Strategies
Further, traders can develop strategies to exploit the trade flow imbalances—when there is a buy-side imbalance; the trader can expect that the price may be going up and thus take a long position in the commodity or vice versa when selling short.
For instance, one could use imbalances pre-empted by volume spikes in conjunction with analysis of order books. A trader could then go long, expecting prices to rise, upon noticing a spike in the buying orders that has not been satisfied by a similar increase in sell orders.

Risk Management
Risk management is a significant part of effective management in this type of trade based on imbalances in trade flow. It usually includes setting up stop-loss orders and keeping a well-diversified portfolio in case unanticipated market reversals happen. For example, a trader may place a stop-loss order slightly below his entry point when taking a long position during a buy-side imbalance. That way, they are protected in case the market reverses—something that most would expect to be upward. For the same reason, one should also spread risks by trading not only various cryptocurrencies but also asset classes to ensure that one adverse move does not undermine the portfolio's performance.

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Mitigating Risks

Hedging Techniques
Hedging involves taking positions in related assets to offset potential losses. An example is a trader who expects a sell-side imbalance in Bitcoin; he might short Bitcoin futures as a hedge against potential downside price movement. This way, they can benefit from the decline, whereas their primary holdings will be hedged against it.
The use of options may also do another approach. Like in the case of put options, one can sell at a preset price to spare the trader from losses on either the upside or the downside, arising from moves caused by a sell-side imbalance.

The trader can evenly distribute positions across different assets, lowering overall exposure to imbalances in trade flow hitting any single asset. This spreads risk so that a trader is not overly tied to the success of one particular cryptocurrency. For example, a trader may have prolonged exposure to Bitcoin, Ethereum, and several altcoins. Now, in case of a sell-side imbalance occurring in Bitcoin, diversified long exposure to Ethereum and altcoins will reduce the losses or even outperformance in comparison with being exclusively in Bitcoin. Such a diversified strategy does not only reduce risk but also captures several market opportunities.

Final Thoughts
Trade-flow imbalance in crypto trading is one of the essential concepts that defines price volatility, price discovery, and market sentiment. Recognizing and following these imbalances gives an excellent idea of how to benefit from market moves.
High volumes of trade brought about by market makers point to a healthy market with adequate liquidity for traders to enter and leave as they see fit. That is what supports price discovery, reflects confidence in the market, and reduces the occurrence of big swings in prices. One strong contributor that helps the generation of these volumes is the set of market makers that ensures smooth operations at the exchange.

​The knowledge of volume authenticity reported, therefore, is paramount for average traders. It allows the trader to be equipped with the knowledge necessary to make an informed choice and keep away from such pitfalls that result from tampered trading volumes. An eye on order book depth helps, complemented by knowledge of the reliability of volume figures. Good market makers and effective trading with well-managed trade flow imbalance are the material contributors to the stability and efficiency of financial markets. Embracing best practices, staying ahead using advanced algorithms, and harnessing real-time data analysis keep their influence pivotal in the moving trading landscape.

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