How Does Market Depth Work?

What is Market Depth?

Market depth, also called depth of market volume (DOM), relates to a market’s ability to absorb market orders without significantly moving the price. Market depth considers a market’s order book at a point in time (bid and offers), price, and volume, with more orders usually producing greater market depth.

Market depth is represented by an order book, published by some brokers, which separates orders into buy (bid) and sell (ask or offered) orders delineated by price. The order book shows the number of shares/contracts being bid or offered at specific prices. The identity of the market participants can also be displayed but most choose to remain anonymous. Order books and market depth are accessible on almost every official exchange across various financial asset classes. As spot Forex is not a centralized market, some brokers make their order book accessible to their clients, and some do not. Spot Forex traders sometimes also use the DOMs published by Forex futures exchanges, but these cover mostly only the major currency pairs.

The liquidity of a market can be determined by the depth of the order book, meaning highly liquid assets should be able to absorb larger order volumes, creating smoother, less volatile price action. In less liquid assets such as small cap stocks and exotic currency pairs, wild price swings and frequent gapping occurs due to thin liquidity, when larger orders can induce significant price swings.

Examples of Market Depth & Volume

Now that we have an idea of what market depth is, we can go into further detail about volume.

 Volume in the context of market depth refers to the amount or quantity demanded on the buy or sell side at a specified price. 

Let’s examine how to read a market depth chart by looking at a simplified example below for Share X:

Sample Market Depth Chart

The market depth chart for Share X shown above includes the top five levels of market depth, each represented by a row, although in practice there will be many more levels which can be viewed depending on your software and trading platform. Beginning on the buy side, we have 500 shares waiting to be purchased at a price of $5250.00 (the best bid) while on the sell side, there are 1650 shares waiting to be sold at $5252.00 (the best ask/offer).

If someone places an order to purchase 250 shares at 5250.00 the order book will then change to reflect this incoming order, resulting in the revised market depth chart below:

Market Depth Chart After New Order

We can see the volume at $5250.00 has decreased by 250 shares (circled in red) to reflect the new order, while the total buy quantity also changed accordingly. The same logic will apply to the sell side. It is important to note that there are various order types that affect market depth in diverse ways. For example, market orders are usually executed very quickly close to the price, so you will not really see market orders in a market depth chart – the orders here will really be just stop and limit orders, which are always entered some distance away from the current market price.

Market Depth Trading Strategy Explained

So, how can the information shown within a market depth chart be used as part of a trading strategy? The first thing to understand is that large orders will tend to attract the price to move towards them. In fact, some traders try to move markets by placing large orders in the direction away from the market price that they really want to see the price move, and then cancelling the order before it is reached. This is called “spoofing” and is generally illegal on most exchanges – in any case, it is a high-risk strategy which requires substantial resources.

In a more general way, you can often use market depth as a method of gauging market sentiment to select the most likely short-term price direction. By analysing the total volume of bid and offer orders within a range of the market price, you can see which side has more weight in the market. 

In the market depth chart shown below, you can see that the total order volume on the sell-side accounts for more than the buy-side, showing the market is likely to have a downwards bias.

Market Depth Chart Showing Sell Bias

A trader could then look to enter a short position or close an existing long position in anticipation of a move lower over the near term. However, as these figures are constantly changing as limit and stop orders are constantly cancelled or entered, particularly in the case of a very liquid market such as Forex, this directional trade bias trading strategy supports shorter-term trading, and so is most suitable for day traders or scalpers.

Another way a trader can use the order book is to identify optimal prices for exits, whether they are profits or losses. For example, if you are in a profitable long trade and you see a huge sell order a few pips above the current price, you could consider taking profit just below the big sell order. Alternatively, if you are in a losing long trade, and you see a huge buy order not far below the current price, you could put your stop loss just below that order, as if sell orders eat through it, it will be a bearish sign.

 I do not recommend using market depth as a standalone trading strategy, but instead see it as a tool for day traders that can be used to optimize another strategy. 

The practice known as spoofing mentioned earlier in this article has not been stamped out and can cause big problems for less experienced traders relying solely on a market depth chart. 

How to Use Market Depth Analysis in Forex Trading

Let’s look at a practical example of Forex trading using market depth and volume. The example below shows market depth on the EUR/USD currency pair along with the corresponding 5-minute price chart over the same period.

EUR/USD Market Depth Table

5-Minute EUR/USD Chart

The arrow shows the time at which the market depth table shown previously above was taken. Total volume on the sell side gives the trader a rough estimate of market sentiment which favors sellers, indicating a downside bias in this case. Secondly, by considering the two levels with the highest volume, a trader can deduce key levels of support and resistance. The 1.08346 level marks the highest point (resistance) in the short-term rally and can allow traders in long positions to potentially close out or give traders looking to short the market a good entry point.

As mentioned previously, relying on market depth only can be detrimental so I have included two additional indicators to corroborate the depth of market volume indicators. Both the MACD (blue) and stochastic (black) indicators are suggestive of a bearish downturn, backing the market depth signals, and could give a trader more confidence in placing a short position. This is just one example of how to use market depth in trading, so it is important to note that there will be cases where even a multitude of approving indicators can be wrong. Making sure you use sound risk management techniques remains important.

Final Thoughts

Depth of market information can be a useful trading tool for short-term traders in a liquid market such as Forex. However, as Forex does not have a centralized exchange, a broker’s feed may have questionable value – the larger the broker, the more useful their depth of market information will be to a trader. Do not forget that not every broker makes their order book available in a DOM chart.

 The best use of DOM information is to help determine very precise entry and exit points for short-term traders. An order book which is heavily tilted towards longs or shorts can also help traders to determine the best direction to trade in over the short-term.

It is important to remember that every DOM chart is just a snapshot of a moment in time and can change radically in a split second. Do not think that using depth of market information is going to give you an indestructible advantage in the market. However, it can be a beneficial tool to use in short-term trading. 

FAQ

How do you read DOM in trading?

DOM allows traders to interpret an asset’s liquidity by presenting supply and demand data. Open bid and ask orders make up this supply and demand data and the greater the number of orders, the greater the liquidity of the asset.

What are top-of-book quotes?

The phrase ‘top-of-book’ describes the best bid and best ask prices for a particular asset without reference to the rest of the order book.

How do brokerages profit from the bid-ask spread?

The bid-ask spread is the difference between the best bid and best ask price of an asset. For example, if the quote on EUR/USD is currently 1.0835 (buy) 1.0836 (sell) then the spread would amount to 0.0001 (1 pip). The spread is the amount brokerages retain as profit for facilitating transactions between buyers and sellers. Although this may seem small, large brokerages conduct thousands if not millions of trades per day.