What Is Market Depth?
Let me explain market depth directly: it refers to a market's ability to absorb relatively large market orders without significantly impacting the price of the security. You need to consider the overall level and breadth of open orders, bids, and offers when thinking about this, and it usually applies to trading within an individual security. Typically, the more buy and sell orders that exist, the greater the depth of the market—provided those orders are dispersed fairly evenly around the current market price of that security.
Key Takeaways
- Market depth refers to the market liquidity for a security based on the number of standing orders to buy (bids) and sell (offers) at various price levels.
- In addition to price levels, market depth considers the order size, or volume, at each price level.
- The greater the market depth, the less likely that large trades will greatly impact a security's price.
- Market depth can be ascertained by looking at level 2 price quotes that can be found in a security's order book.
Understanding Market Depth
You should know that market depth, or depth of market (DOM), is closely related to liquidity and volume within a security, but it does not mean every stock with high trade volume has good market depth. Evaluate it by looking at the order book of a security, which lists pending orders to buy or sell at various price levels. On any given day, an imbalance of orders can create high volatility, even for stocks with the highest daily volumes.
Here's an important point: the decimalization of ticks on the major U.S. exchanges has increased overall market depth, as shown by the decreased importance of market makers, who were needed in the past to prevent order imbalances.
Market depth derives from all the orders in a security's order book at any given time. It represents the amount that will be traded for a limit order with a given price—if not limited by size—or the least favorable price obtained by a market order with a given size—or a limit order limited by size and not price.
Although a price change might attract subsequent orders, we don't include that in market depth since it's unknown. For example, if the market for a stock is deep, there will be sufficient volume of pending orders on both the bid and ask side, preventing a large order from significantly moving the price.
Depth of market also refers to the number of shares of a particular stock you can buy without causing price appreciation. If the stock is extremely liquid with many buyers and sellers, purchasing a bulk of shares typically won't result in noticeable price movements.
How Traders Use Market Depth Data
Traders use market depth data to determine where the price of a particular security could be heading. For instance, you might use it to understand the bid-ask spread for a security, along with the volume accumulating above both figures.
Securities with strong market depth usually have strong volume and are quite liquid, allowing you to place large orders without significantly affecting the market price. On the other hand, securities with poor depth could shift if a buy or sell order is large enough.
Market depth data typically appears as an electronic list of buy and sell orders known as the order book, organized by price level and updated in real-time to reflect current activity. In the past, this data was available for a fee, but now most trading platforms offer some form of market depth display for free. This lets all parties see the full list of pending buy and sell orders, along with their sizes—instead of just the best ones.
Real-time market depth data allows you to profit from short-term price volatility. For example, if a company goes public and starts trading, you can watch for strong buying demand, signaling that the price could continue upward.
Example of Market Depth
Consider this order book example for the security MEOW shares, where the current quote is $13.62 – $13.68, with 3,000 shares on the bid and 500 shares on the offer. The depth of bids shows that if all 3,000 shares were sold at $13.62, the next best bid would be $13.45, but only for 16 shares.
If you had an order to sell 10,000 MEOW shares at the market, you would sell all the available bids down to $13.35, where there's a standing order to buy 43,500 shares. Selling 10,000 shares would thus move the market down nearly 30 cents, or about 2%. This indicates a low level of market depth.
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