Market depth is a volume indicator that shows how much a large order will impact the price of a stock or derivative. Securities with more market depth won’t be as affected by a big order as securities with low market depth. Many brokerage firms show market depth as a listing of the current bid and ask offers for the security.
Market depth is an important metric to study when trading in low-volume stocks or futures contracts. Let’s go over how it works and what it means for individual investors.
Definition and Examples of Market Depth
Market depth, or depth of market (DOM), is a measure of liquidity in a stock or derivative that shows how the price will be affected by a new order. Market depth is typically presented as a table of current bid-ask prices and how many traders are willing to purchase at those prices.
Market depth is used for two main reasons: to learn about the general liquidity of the security, and to determine whether one large trade will move the market. The former is more important for individual investors, and the latter for large institutional investors.
Here’s an example of market depth for a hypothetical stock. This table is similar to how a brokerage firm such as InteractiveBrokers or TD Ameritrade would show market depth.
The first size column on the left shows how much volume is available to buy the stock at that ask price; the far-right size column shows who is willing to sell at that bid price. The difference between the two is the bid-ask spread.
There are fewer traders willing to buy the stock as the price goes up, and more current holders willing to sell as the price goes up. This should make sense intuitively.
You can also use this table to determine what prices you will pay for a large order. Let’s say you need to put in an order for 175 shares. You would be able to buy 25 shares at $5.10, 50 at $5.30, and 100 at $5.56.
How Market Depth Works
Market depth typically can be found on trading software or on brokerage websites. For all but the most thinly traded stocks, it is a snapshot of the current bid and ask positions of the stock.
When a large order (to buy or sell) a stock is made, it can affect the market with the mechanism discussed above, by taking up all the available shares at various bid-ask levels. There is also an argument that market depth is affected by asymmetry of information. That is, the market assumes that the people making large orders have more or better information than the people making small orders. So if a large buy order is put in, smaller traders will race to join in, assuming there is something they don’t know.
Liquidity providers also affect market depth. If there is a lack of liquidity in a stock, institutions may not want to take on a full order, requiring the trader to use multiple institutions to move in or out of a large position.
Market depth also can be used by traders to determine when to enter a trade.
If the orders are biased in one direction, that can signal in which direction the stock price will move. For example, if 60% of orders are to buy and only 40% are to sell, the price will likely go up due to that buying pressure.
Additionally, traders can look for the point when sell orders start to overtake buy orders to find levels of resistance—and when buy orders start to overtake sell orders for levels of support. It is likely that the stock would remain within these support/resistance bands until something substantive changes.
What It Means for Individual Investors
Market depth is more important for individual investors to use when gauging the general liquidity level of a security. There aren’t many individual investors capable of moving the market for most stocks.
Of course, there are exceptions. Micro-capitalization stocks trading on over-the-counter (OTC) markets and thinly traded derivatives may be illiquid enough that individual investors would need to check the market depth to ensure they won’t move the market with an order. Use the method in the table example above to determine how much a large order may affect the price of the stock or derivative.
Also, even if individual investors don’t possess the buying power to move many stocks, they can still be affected if liquidity is low. If a large institution owns 10% of a stock and decides to sell it, the stock will fall more if market depth is low. And the better the market depth, the less impact bad news will have on a stock because one seller won’t control the market for it.
As far as general liquidity goes, it’s important to know that a limit order will be executed soon once your trade is placed, and also to have confidence that when the time to sell comes, the market will have someone available on the other side of the trade to buy from you.
- Market depth is used as a measure of how much one big trade will affect a stock or derivative price.
- Market depth is presented as a collection of buy and sell offers at various prices clustered around the current price.
- Traders use market depth to help identify support and resistance levels, and to determine if a stock may move up or down, based on the number of buyers relative to sellers.