Market depth is defined as an indicator that shows the impact of large orders on derivatives or stocks. In comparison, big orders affect securities whose market depth is higher, while those with a low market depth are less affected. Most brokerage agencies offer you a list of the bids at that period, alongside the security’s ask offers.
Understanding market depth as a metric is essential for your low-volume stocks trade or when undertaking future contracts. The information compiled in this context gives you an in-depth understanding of this concept, how it works, and its importance to you as an individual investor.
What is Market Depth?
As a trader or investor, it’s essential to ask yourself this critical question: What is market depth? Depth of market (DOM), also called market depth, measures the liquidity of stocks or derivatives. It outlines the impacts of new orders on the existing prices of securities, showing the number of traders willing to trade under the outlined bid-ask prices.
You can use market depth to know the impact of a big trade on the market, determining whether or not there will be movement in stock price. This is greatly useful for large institutional investors. DOM is also important to show a security’s general liquidity, which helps you calculate your moves in the trade as an investor.
Examples of DOM
Suppose an investor or trader is monitoring the market depth of Stock X with a current share price of $1. It also happens that 100 offers are going for $1.12, 125 offers for $1.10, 250 for $1.08, and another 250 offers for $1.05 each.
On the other hand, the other 10 offers are $0.92, 10 at $0.93, 40 at $0.95, and 50 offers for $0.98 each.
After studying this trend, the trader concludes that Stock X is moving upward, helping them decide whether to sell or buy the stock.
The table below offers you a more straightforward example of the depth of market for a stock that’s hypothetical. It highlights a similar outline to that of a brokerage firm.
The table consists of four columns labeled size, bid, ask, and size. The first highlights the available volume willing to purchase stock at the listed ask price. The last column labeled “size” shows the traders available to sell under the given bid price. You can differentiate between the two “size” columns on the far left and far right sides by considering the bid-ask listings.
Focusing on this table, you’ll realize that investors are unwilling to purchase the stock when the prices are high, while more sellers are willing to give up theirs during high prices. This is an intuitively sensible chain of occurrences in the stock market.
The table can assist you in understanding the prices charged on shares when the orders are large. For instance, if you want to buy 175 shares, you can divide the order into smaller portions and get 100 shares at $5.56 and 75 at $6.10. You can add more, depending on the order size you require.
How Market Depth Works
Market depth data issues you with a clear image of the stock’s position in the market in terms of bids and asks. You can derive market depth charts or tables from brokerage websites or trading software.
Large orders impact the market by absorbing most of the shares in different bid-ask categories. The depth of the market operates under the assumption that traders with large orders are better informed and more conversant with the market “tricks” than those raising smaller orders. This mechanism convinces the latter to rush and join in the purchase since they feel like the big order traders have hidden information that’s not available for them.
The market depth also operates under the effects of liquidity providers. Trade institutions refrain from taking up big orders when the market lacks liquidity. This forces traders to move to several institutions seeking to get in or out of such orders.
With the full knowledge of the market depth, traders can decide when it is safe to enter or exit a trade.
In cases of biased orders, the stock price takes the direction that traders deem most favorable to them. For instance, if there are 40% to-buy orders and 60% to-sell orders, the share prices can shoot upward, resulting from the high buying pressure.
In addition, traders remain keen to identify points where sell orders are higher than buy orders and take advantage of resistance levels. At other times, they wait until buy orders start overtaking sell orders to identify levels of support. If there are no significant changes in the market, the stock is likely to maintain its resistance/ support bands for a while.
Impact of Market Depth on Individual Investors
Individual investors have the most use for market depth as it helps them gauge a security’s liquidity levels. However, few investors can move the market when trading most listed stocks.
However, some individual traders can comfortably handle micro-capitalization stocks whose trade markets operate using over-the-counter (OTC) terms. This makes them illiquid enough for these traders to prompt individual traders to counter-check the market depth table to know the impacts of large orders.
Some individual traders have limited abilities to move multiple stocks at a go but still suffer the impacts of low liquidity. When large institutions dispose of 10% of their stocks, the fall will be more impactful during a low market depth. If the market depth is better, the stock will not have a big effect because the market is already stable, and one seller cannot control it in that state.
Regarding general liquidity, you should understand that placing your trade prompts a limit order that ensures you have prospects to buy your shares when you decide to sell.
How to Use DOM Data
As a trader, market depth helps you know the status of a security’s price and the direction it’s likely to take in the future. You can monitor orders that get canceled, updated, or filled and use the data to determine a stock’s bid-ask spread. You can also check the market’s current volume.
The popularity of a stock increases as its market depth grows stronger. Such stocks also have high liquidity levels and large volumes, meaning that traders can make large orders without interfering with the prices in that market.
In comparison, stock prices are highly affected when the market depth of a specific security is poor. One trader can cause significant impacts by moving the market when they place a colossal sell or buy order.
The ability to view the market depth information as it unfolds helps you maximize your profits when the prices face short-term volatility.
To wrap it up, the depth of the market is an essential metric to inform you of the impacts of a large trade on derivative or stock prices.
It is outlined in terms of sell offers and buy offers under different prices, and you can choose the most suitable one depending on the market’s current status.
You can also use the information to point out resistance and support levels, helping you determine stock’s upward or downward movement. This enables you to make a more informed decision on buying or selling your shares.