All About Delta
So what is it?
Delta is a way to measure the balance between Buyers and Sellers across trades which occur at the same price (or range of prices) during a particular period (e.g. a 5-minute bar or 1000 tick bar). To build on this definition we need to go a bit deeper into what is actually happening when you enter a trade and consider what we mean when we say Buyer or Seller - as in reality, every single trade involves both.
To simplify matters, let's assume there are only two types of order, Market Orders and Limit Orders, and we're primarily considering the futures market - although the concept is more broadly applicable.
If you click the Buy button, you are instigating a Market Order to buy at the current (Market) price. The price the trade gets filled at is not guaranteed - if price moves before your order is filled, you'll get filled at the new price which could end up being a better price, or (more usually!) a worse price. The point is, you wanted to get into the trade immediately and were more concerned with getting into the position than the exact price you got in. This could be deemed as an aggressive entry method.
The alternative is to enter a Limit Order to Buy, where you choose the exact price you are willing to trade at. If you were trying to Buy with a limit order, you'd be placing your order somewhere below the current trading price, hoping price ticks down and fills your order. This is a good way of getting filled at an advantageous price, but you run the risk of missing out on the move if price takes off without first ticking down to your order. This could be deemed as a passive entry method.
In either of these scenarios, once you're filled, you become the proud owner of a shiny new contract; but there are some differences to consider. If everyone was passive there would be Limit Orders sitting on the Order Book, but nothing actually happening - everyone is passively waiting for somebody else to blink and get an itchy trigger finger! Therefore the market needs somebody to instigate a trade by entering a Market Order.
With this understanding, you can see that your shiny new contract exists only because another party is on the other side of the trade - if Buying at Market, you're matched with the first passive Sell Limit Order queued up at the nearest price on the Book at that time. For every trade that occurs at a given price we can determine whether the instigator (Market Order) of the trade was a Buyer or a Seller. Over time many trades will occur at the same price, some instigated by a Buyer and some by a Seller, and we can calculate the difference between the number of contracts bought vs sold at Market to get a value for Delta - which is then defined by +/- a number of contracts.
When we see a positive Delta we can say there was more volume instigated by Buyers than Sellers at that price or during that time period, and we can track how the Delta changes as a way to judge the urgency behind a move.
This is one way to look at Delta, however it's possibly more important to examine the perspective of the participants whose Limit Orders have been filled...
Understanding market participants
If we can understand who is on the other side of our trades, and how they operate, we can potentially use this information to improve the quality of our own trading decisions. Most of us are Speculators in terms of the role we play in markets - we're looking to make a quick (or not so quick) buck - we aren't taking delivery of Wheat Futures in order to feed livestock on a farm (Real Money) and we aren't buying Oil Futures to offset the costs of fuel to our haulage business (Hedgers). While there are many large participants in the markets, with the majority of them we can never know when, where and why they will be active. There is however one group we know will be almost constantly active in the market; Liquidity Providers.
Each exchange has different rules and requirements which must be fulfilled to qualify, but their primary function is to "provide competitive firm bid and offer prices and size throughout the trading session to attract customer order flow". A variety of incentive schemes and rebates are available to those providing liquidity in this way - which result in very low costs of trading and often outright cash back.
The % of daily volume which is provided by LP's is difficult to accurately measure, but estimates vary upwards from 30%. The desks and institutions which provide this liquidity can essentially be viewed as having an unlimited supply of money - if they so desired, they could provide enough size to hold the market at one price (acting as an iceberg) all day long, but this would generally not be a cost effective strategy!
These players invariably use algos which work the Limit Order Book, trying to be first in the queue so that they are on the other side of as many trades as possible. Their aim is not to profit from a directional view of price, but rather to execute a trade and then get out of it as soon as possible, making just the spread (1 tick) - they don't want to 'cross the spread' when possible as that incurs a cost. If order flow becomes heavily directional (toxic flow) the algos just build inventory and will look to balance the inventory at a later point, as and when price returns to the various locations and break even prices where trades were initially filled.
The skill and edge in such an algo is to accurately judge the buying or selling pressure at any given moment, and to pull prices further away from any pressure which is judged to be non transitory. Many ingenious techniques are used to determine the state of play, one of which is watching how other participants are acting. If the Order Book shows bids or offers pulling away from price it could well indicate incoming toxic flow, and it may make sense to also move. If the pressure at a particular point is not 'overwhelming', the algo is free to 'optimize behaviour to reduce inventory' or to 'attract customer order flow', which usually amounts to the same thing.
Limit Order Density
While Market Orders are the reason price is moving, LP's control of the Order Book - combined with the sensitivity and herd behaviour of other LP algos - means that it is possible for them to influence market direction by skewing price and size of Limit Orders in a way that benefits their inventory balancing strategies. This results in the density of the Order Book varying at different times and zones as the algos are more interested in doing business on one side than the other.
The effect of these density shifts can result in zones of extreme Delta, as Limit Orders absorb Market Orders within 'thick' areas and in a lack of Delta in the sparse 'thin' areas. If we can track and visualize these zones of Delta as they grow, and view them in a way that highlights the relative importance and size of the extremes, we can use the zones to Enhance our Edge.
The behaviour of LP algos will cause them to seek out and Utilize or Neutralize these areas in order to re-balance inventory or attract order flow. We can therefore recognize Delta Zones as both a target for price and a location where price is likely to react; as they often exist at the point where an inventory re-balance is completed.
Once you see the effect these Delta Zones have on price, you'll see why a lot of other concepts like Supply & Demand actually work. Though you'll now have a much better understanding of when these concepts will work and when to expect them to fail.