Hierarchy of Indicators

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss the importance of thinking about your indicators. Think about the way you think about the market and how it fits in with the hierarchy. You want to make sure that you rely on leading indicators, and that you understand the role that lagging indicators play.

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

When we look at the market, and we look at how an order first shows up in the market, then how that order transitions into a transaction of volume, then how that volume influences the market, and how that influence in the market is captured via different indicators. This is what I say when we talk about the hierarchy of indicators. Most traders are using a set of indicators on their chart, and they don’t know why they’re using them. Other than that, they learned them in a class or they read them in a book, or they look interesting.

We have to be better than that.

We have to think about why do we do what we do, because when we ask the question why, we deepen our understanding. When we deepen our understanding, we gain confidence. We gain self confidence in our ability to trade. So today we’re gonna talk about this hierarchy of indicators.

You notice here in a hierarchy of indicators that there’s a red line, and above the red line is what we call leading indicators. Below the red line is what we call lagging indicators. What we’re going to see here is these different categories and how they manifest themselves through the market.

We start with an order flow.

Order flow is the first time there’s any type of intention of somebody to do something. An order flow eventually is either cancelled, expires, or transacts. When an order transacts, the amount of contracts or shares that are traded in the transaction creates the volume. Volume leads to volatility, volatility to momentum, momentum to trend, and trend to overbought and oversold.

Order flow is the first observable sign of activity in the market. It shows passive bids and offers in the market. These passive bids and offers can be interpreted to influence the market. For example, an imbalance of bids, having a lot more bids than offers in the market, would lead to the conclusion that the market is strong. But order flow can also be gained and manipulated.

There’s the term called spoofing, which is now technically illegal.

Spoofing is when you place a large order or a series of orders in the market to try and influence the trader to make the opposite trade. What this means is, you start putting in bids and bids and bids and make it look like the markets really strong. Or in our case, here, we could place a large bid one level below the market, and people would see this, there’s an imbalance of bids to offer. So they jump in to buy and when they jump into buy they’d sell to them, and then pulled the bid. That’s spoofing. So they’re gaming people who are trying to read the market.

Order flow is the best indicator.

Proprietary trading firms and banks literally spend millions and millions of dollars for the right to order flow. And that right to border flows for two reasons. It’s to see what’s going on. And it is to transact with it. The combination of these two is worth a lot, whether it’s electronically, or whether it’s a voice in IM. So when you look at professional traders, professional traders, first and foremost, look at order flow.

Now the problem with order flow is that you can only look at a handful of markets using order flow. If you just trade the s&p then yeah, so order flows really good. If you’re trading 100 different things, order flow is too complicated. It’s too nuanced. If I showed you order flow, you would need time to acclimate to that market to understand what the order flow means. It’s nuanced. So those nuances break down if you’re trying to follow over 50, 100, 200 products.

Once order flow transacts, it’s Volume and Volume is the first confirmed activity the market cannot be gained. Transacted volume either creates impact or no impact. Volume can be tracked to know the specific prices and a specific amount of shares or contracts that are contracted or transacted at a price. Volume allows us to track the activity of large players or large participants by sell activities. Order flow and volume are the only leading indicators we have. Both lead the market by influencing flow, by flow, or impacting by volume.

Flow influences and volume impacts.

All other indicators react to these two and they lag. Now we get below the red line and impactful volume leads to volatility because impactful volume destabilizes the market and causes volatility. Impactful up volume causes sellers to remove their sell orders and shorts are forced to cover. This leads to range expansion which creates volatility. Volatility now goes to momentum. Volatility that persists leads to momentum. Impactful up volume causes the market to continue to rally, which forces additional short covering and brings in momentum buying.

Momentum that persists leads to a trend.

A long lasting trend will have waves of impactful volume that start the cycle all over again while the market continues to move higher. So a trend is really a series of momentum waves. Volume, volatility, momentum and trend all can have their own overbought or oversold characteristics. So in the case of momentum, momentum that is too extreme leads to the market being too stretched. It’s like a rubber band, it’s too stretched. If it stays too stretch too long, it’s going to snap back. Trends that persists to long create overbought, oversold.

Overbought, oversold conditions lead to reversion one of two ways.

There’s a sharp reversal in price that results in volume traps that caused recent participants who are in the trade to cover or overbought, oversold conditions get resolved by going sideways. So I would say there’s two ways the market reverts. It reverts by going back to the mean or it reverts by going sideways in the mean catching up.

Think about your indicators. Think about the way you think about the market and how does it fit in with this hierarchy. You want to make sure that you rely on leading indicators, and you understand the role that lagging indicators play. They can be really helpful, but we need to understand that they’re lagging . The combination of these to create a very powerful framework.

Stick around, check in next Tuesday for our next episode of Trader Tip Tuesday. I always say that I’d make it worth your time to come here and learn because I want to help you take your trading performance to an elite level. I’ll see you next week. Bye.

~Chuck Whitman