How to Organize Your Charts with Market Layers
Let's peel it back...
Analyzing a chart can be a confusing task when you’re not sure how to effectively organize the information. It’s very easy to feel overwhelmed when you have conflicting signals coming from multiple sources in your analysis.
For example, price action suggests it’s staying sideways, your indicator suggests it’s going up, and your moving averages suggest it’s going down.
It’s not easy to make a decision. For clear, high-quality analysis, we need to understand what we’re looking at on the chart properly. The market is organized into “layers.” Imagine these layers as an onion, where the outer layers stem from the inner layers.
Layer One:
The first layer of the market is the foundation upon which everything else is built. It represents the most fundamental aspect of the market - the interactions between buyers and sellers.
These interactions are the building blocks of the market. This is the centerpiece of our onion, the market in its purest form. Tools like Depth of Market (DOM) and the Order Book can be used to visualize this activity in real time. Traders who rely on these tools are known as order flow traders.
These tools, such as the DOM above, display a ladder of prices with the current market price highlighted in yellow. The left column shows the limit orders (bids) placed by buyers, while the right column shows the limit orders (offers) placed by sellers.
At the price of 2899.50, there are 444 offers. This means 444 shares are being offered by the sellers. For the market to reach this price, buyers would need to buy all of the 232 offers at 2899.00, and then move up and buy all 435 offers at 2899.25.
If there are many offers at each price level, more buyers are needed to push the price up. If there are fewer offers at each price level, fewer buyers are needed to push the price up. You can think of it like trying to move through a thin forest compared to a dense forest. The fewer obstacles you have, the faster you can move. The same is true for sellers in the opposite direction.
In smaller and less liquid markets, analyzing the DOM (depth of market) and the order book can still be useful. However, in larger and more liquid markets, it can be very hard to interpret these tools due to the dominance of high-frequency trading and algorithms.
It can be hard to wrap your head around these concepts at first. They can be valuable resources, but they require a lot of expertise to use as primary tools. While not necessary to master, it’s important to have some understanding so that you know how the market functions.
Layer Two:
This layer is the middle layer of our onion, derived from layer one. It consists of price action, volume, and support and resistance levels.
Price action is typically depicted using candlesticks or bar charts, but can also be applied to other chart types such as line, Heikin Ashi, Renko, point and figure, tick, and many more.
Let’s say we’re observing the DOM, and stock XYZ is trading at $20.00. There is an offer to sell 500 shares at $20.01, and buyers come in with an order to purchase 500 shares. All of the orders will be filled, and the price will tick up to $20.01.
On a candlestick chart, this is what we will see in real-time:
Charts are a way of organizing and displaying the data from the buying and selling activity that can be observed in the DOM and Order Book. By analyzing this activity over time, patterns may emerge that suggest the price is more likely to move in a particular direction.
These patterns, which may be individual candlestick patterns or chart patterns, are easier to interpret than tools in layer one, but can still be difficult to discern due to the high level of noise.
Price action is a solid foundation for trading. Some traders rely solely on price action and have successful careers, while others view it as the most important factor in their analysis. In addition to price action, volume and support/resistance can be useful layer two tools to enhance your analysis.
It is essential to have a good understanding of price action. This can be difficult to grasp when starting, but it is a crucial skill that separates professional traders from amateurs.
Layer Three
Layer three, the outer layer of our onion, is derived from layer two. It consists of indicators, averages, and anything else derived from price or volume. It's a huge category.
Indicators are formulas based on price action or volume. The process involves taking data from your chart, plugging it into a formula, then giving you results that you can use to evaluate current conditions. Broadly, we have four types of indicators:
Trend (Moving Averages)
Volatility (Bollinger Bands, Keltner Channels)
Momentum (RSI, MACD)
Volume (OBV, Volume Profile, VWAP)
They can often point things out that we aren't able to see clearly on the chart. It's best to stick to one or two and get to know them intimately.
You should know how your indicator is calculated. It's not necessary to manually calculate on paper (although it would be helpful), but at least have an idea of how your indicator is derived. This way, it won't be some magic line that produces buy and sell signals. You'll be aligned with price action and your indicator, so you'll be able to more accurately distinguish between signals that are useful and signals that are just the result of noise.
Putting it all together
This is an introduction to organizing your charting in a way that is structured and allows you to make clear decisions. In an environment as chaotic as the market, it’s crucial to stay grounded and composed. Emotions and confusion can have disastrous consequences.
Once you have mastered and connected the three layers, you’ll have a deeper understanding of the market and a stronger sense of direction. This clarity will elevate your trading from shooting in the dark to taking precise and calculated shots.
This concludes our discussion. Subscribe and stay tuned for more!
- Tradewriter
Disclaimer: Any content from this newsletter should not be taken as financial or investment advice, but for informational and entertainment purposes only. This newsletter simply shares my personal opinions. Investing in stocks, bonds, futures, options, and other securities carries significant risks. Some or all capital may be lost. With leveraged instruments, losses may exceed initial capital. Past performance of a security does not guarantee future results. Consult with a registered financial/investment professional. This newsletter and its authors are not licensed financial/investment professionals. By reading and using this newsletter, as well as any other publications, you are agreeing to these terms.