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How to Read a Depth Chart

How to Read a Depth Chart

Depth charts are often overlooked by beginners but they offer a wealth of important information that can help you make better trades. 

 

They can be incredibly easy to read once you understand the layout and they can give you quick, visual feedback on things like the bid-ask spread, order book depth, potential support and resistance levels, market liquidity, and more!

 

This article will help you understand how to use a depth chart and get the most out of this powerful trading tool. 

What Is a Depth Chart?

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A depth chart is a type of trading chart used in financial markets. 

 

Depth charts visualize the volume of established BUY and SELL limit orders at various price levels.

 

They also give a detailed view of crucial market data, such as order book depth and the bid-ask spread. These metrics provide the user with a better understanding of market liquidity, they help them spot potential entry and exit points, and even identify market manipulation.

Deconstructing and Understanding Depth Charts

A depth chart is comprised of three main components:

 

  • The horizontal X-axis, showing a range of prices.
  • The vertical Y-axis, representing the volume of placed limit orders.
  • The market depth indicator, depicted by colored areas within the chart (SELL limit orders in red and BUY limit orders in green).

 

You will notice the two sides of the depth indicator converging in the middle of the chart. 

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Surprisingly, if you zoom in you’ll see that they never actually touch. This is because of the way order book trading works.

Order Books, Market Makers, and Market Takers

An order book is simply a list of limit orders split into bids and asks. Traders known as market makers place bid (BUY) and ask (SELL) limit orders and other traders called market takers “fill” these orders by agreeing to trade at the specified price.

Market Depth

Market depth is measured by the combined size of all the limit orders in an order book. 

 

When a market taker makes a trade with a market maker it’s said that the market taker “fills” that order. As limit orders are filled they’re removed from the order book, thereby decreasing it’s depth.

 

New market makers need to come in and place more limit orders to grow the depth of the market.

Putting It All Together: How to Read a Market Depth Chart

The colored areas on a depth chart represent how the volume of bid (BUY) and ask (SELL) limit orders, set by market makers over various price points, is distributed. 

 

The distance between the closest bid and ask price is what’s known as the bid-ask spread. The bid-ask spread refers to the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). 

 

This space is where price discovery (i.e., price movement) happens thanks to market takers who fill up either side of the order book.

Note: Keep in mind that these orders can be canceled or modified at any time. As the price of the traded asset changes, traders will make adjustments to the sizes of their orders and the price at which they want to trade.

Liquidity

The most straightforward use of a depth chart is for gauging market liquidity. 

 

Liquidity is a function of market depth and the bid-ask spread. In other words, the more bids and asks there are, the bigger they are, and the tighter the spread, the more liquid the market. Liquid markets tend to be more stable, less vulnerable to shock events (e.g., negative news, large individual trades, etc.), and safer for beginners. 

BUY and SELL Walls

A BUY or SELL wall is a large and sudden jump in limit orders on one of the two sides of a depth chart. 

 

BUY and SELL walls usually form at price support and resistance levels identified by market makers but they can also be the result of individual market participants trying to influence others.

Impact on Liquidity

Large BUY or SELL walls can impact market liquidity. A significant BUY wall can act as a cushion, absorbing SELL orders and preventing the price from dropping too rapidly. Conversely, a substantial SELL wall can act as a barrier, preventing the price from rising until the wall is fully consumed.

Strategies for Traders

Traders can use BUY and SELL walls to their advantage. For instance, day traders might place orders just in front of a significant BUY wall, anticipating that the wall will act as support and prevent the price from falling further. 

 

Important: Approaching such strategies with caution is essential, as walls can be removed or adjusted without notice, especially in cases of whale market manipulation.

Spotting Market Manipulation With a Depth Chart

As mentioned above, a depth chart is one of the handiest tools for spotting potential market manipulation. Specifically, by using a depth chart and analyzing BUY and SELL walls, you can spot suspicious whale activity. Here’s the rundown:

Whale Activity in Cryptocurrency Markets

In crypto traders who command large sums are known as “whales” and they often use their outsized market share to influence smaller traders.  

 

Suppose a whale believes that the price of a particular cryptocurrency is about to rise. To reinforce this belief and potentially trigger a buying frenzy, the whale might place a massive buy order at a specific price level. This creates a significant "BUY wall" on the depth chart. Other traders, upon seeing this wall, might interpret it as a strong support level or a sign of impending bullish activity, leading them to buy as well. This can drive the price up, allowing the whale to sell at a profit. Conversely, a whale expecting a price drop might set up a large "SELL wall" to create bearish sentiment.

Identifying Genuine vs. Manipulative Walls

It's essential to differentiate between genuine BUY/SELL walls and those set up for manipulation. 

 

Genuine walls often appear at support and resistance levels. They tend to remain in place and get chipped away over time as trades are executed. Manipulative walls, on the other hand, might be removed suddenly once they've served their purpose, especially if the market doesn't react as the manipulator intended. 

 

One way to verify the legitimacy of a BUY/SELL wall is to look at the historical trading volume when that specific price has been reached before. If the volume is large, it’s more likely that the wall is genuine. 

 

Note: Not all walls resulting from whale activity are manipulative. Some may come from genuine investment strategies. Keeping that in mind, it’s important to always be careful when trading around such walls. Moods change and both individual traders and entire markets can shift course in a short time.

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