There are several simple indicators that traders can use to gauge market activity. Among them, market depth, or depth of market, is one of the more useful ones for initiating trades. It’s an effective way to measure a particular asset’s liquidity by looking at orders in the market. If you’re curious how it works, read on.
Market Depth, also referred to as Depth of Market (DOM), measures the supply and demand balance based on the number of open buy and sell orders for a particular asset. The DOM is represented as a list as shown in the table below:
The top row in the Buy segment refers to the highest price a buyer is willing to pay. Similarly, the top row in the Sell part is the lowest price at which sellers are available. Trades are executed when buyers’ and sellers’ demands match.
The information can also be presented in charts. Here are two popular market depth graphs:
Market depth compares the activity of buyers and sellers and helps understand the interest of investors in the particular asset. The greater the number of orders, the deeper or more liquid the market. Many of these orders may not get filled since there might not be a match between what buyers are willing to pay and what sellers are willing to accept.
The list above is easy to interpret, making DOM one of the most straightforward tools to use for trading. When there are buyers offering to purchase at higher prices, one can expect the price to increase. On the other hand, if there is increased selling interest, the price will likely drop.
DOM is important because it signals the potential price behavior based on the active orders. For liquid assets, a single order won’t impact the price much. However, it might significantly affect the price of less frequently traded assets. High-volume orders usually impact the price of instruments, which is why, in the case of whale investors, trading is usually done OTC.
Market depth is also crucial in validating price movements predicted by technical indicators. For example, an ascending triangle may generate a “Buy” signal. If the DOM backs this up through higher buy volumes, the trader can be more confident and proceed further. This is one of the main reasons why DOM levels are also monitored along with trading volumes.
Bear in mind that the DOM doesn’t guarantee the execution of the live orders. A trader can place limit orders and later cancel these trades. Some can use such strategies to manipulate the price, especially for illiquid assets in which a single order can distort the perception of other traders.
Factors That Affect Market Depth
Market depth can be influenced by several factors, including:
Tick size: Tick size is the minimum amount by which the price of an asset can move. The tick size is especially small in the case of foreign exchange. A smaller tick size increases the market depth of the particular asset. Smaller tick sizes ensure that price movements aren’t very drastic. Therefore, the trader needs to generate a higher trade volume to realize a substantial profit.
Margin Requirements: Higher margin requirements mean that a trader has more of his capital locked up for a particular trade. This, in turn, leads to a lower depth since it limits the disposable funds. Relaxing the margin requirements can improve market depth, but it is also riskier since it facilitates the use of more leverage.
Restrictions on Price Movement: Most exchanges curb price movements. Such limits can have a detrimental effect on the DOM. For example, circuit breakers are imposed on stocks that limit trading if the price increases or drops by a certain percentage. The threshold limits can vary for each stock. Companies with lower-level circuit breakers may not support high trading volumes.
Trading Restrictions: Many stocks may not have a derivate (futures and options) market due to restrictions placed by exchanges. Such restrictions also impact market depth. Trading can be temporarily halted for companies under investigation.
Market Transparency: Most investors prefer to invest in a transparent market with readily-available reliable information. Markets with informational asymmetry or lack of transparency transparently can promote illegal trading activities. For example, insider trading and using material non-public information to trade can result in a loss of confidence among investors in the market, which, in turn, can lead to an outflow of funds and decrease market depth.
The above factors are universal and can potentially affect various instruments, including stocks and futures contracts. However, there can also be additional asset-specific factors that can influence the price. For example, a stock with a strong promoter holding and low float may not be heavily traded on exchanges leading to a lower DOM. A stock recently added to an index may see a surge in the DOM figures as more investors look to add it to their portfolio.
How Traders use DOM data
The DOM data can be helpful for forecasting potential price changes. To understand investor sentiment towards the stock, one can compare the market depth levels across different timelines. Traders can use DOM data to supplement other tools like technical indicators. The depth of the market also works as a standalone measure for predicting future price movements. One should, however, not simply rely on DOM data and place trades based his conclusions only on the indicator’s figures. Since the data can be easily manipulated, it is advisable to monitor past orders actually executed to better understand the real demand and supply.
Traders also use DOM data during key events involving a company or an asset. When a company releases its earnings, DOM can serve as an effective tool to understand traders’ behavior. Sometimes the subscription level of an IPO may not portray the real picture of the demand, and DOM can be used to generate short-term gains on the listing date. Likewise, any regulatory action may impact the trading volumes. That is why it is essential for traders to actively monitor market depth when regulators are involved.
Advantages and Disadvantages of DOM Trading
A few of the advantages of using DOM for trading are:
Easy to interpret: The inputs for DOM are price and volume. No mathematical equations or sophisticated calculations are required to understand the market depth, making it one of the most straightforward trading tools. Traders can find out what is going on in the market at first glance.
Real-Time Information: Many technical indicators lag, meaning they depend on past prices, which may cost you trading opportunities. DOM gives you real-time information.
No additional charts are required: One doesn’t need access to charts that may require a paid subscription. There is no need to configure any metric to understand the market depth.
DOM trading can have its share of disadvantages as well. These include:
Subject to manipulation: Any trader can place an order, which would reflect on the DOM chart. These orders can inflate the demand and supply figures to create a false impression among traders.
No information on trades executed: To actually understand the dynamics of price and volume, one needs to refer to the actual price at which the transactions were executed. DOM charts don’t provide this information.
Practical Example of DOM Trading
To understand how DOM trading works, we will refer to Apple’s stocks.
The event marked as ‘E‘ is the date on which the company’s earnings were released. Investors were drawn to the stock after the announcement as trading volumes surged. The actual trading volume was higher on the day when the price surged compared to the trading volumes during the last few trading sessions.
A trader could have observed the DOM charts on this day to understand how buyers flocked to buy Apple shares following the announcement. Since it is a blue-chip company, the possibility of manipulation through false trades would also be less likely. A trader could have placed a profitable trade by observing the patterns in DOM charts and by referring to the latest events that were taking place at the time.
DOM charts combine efficiency and simplicity to give you a real-time picture of the market dynamics. This makes it a valuable supplement to all the additional technical indicators that traders use. DOM can be especially beneficial when around events, drawing the attention of investors. However, similar to most indicators, a trader shouldn’t use market depth on its own.