Market Depth and Order Books in Trading

The price of an asset is shaped by supply and demand, and traders make their decisions based on their ratio. A list of buy and sell orders for a specific security or currency arranged according to a price level is known as the order book, allowing traders to estimate the volume of pending orders, which can be used to identify resistance and support levels and the potential direction of a trend.

What is Depth of Market (DOM)?

Depth of market is the market's ability to absorb large volumes of trades without a significant change in rates. This is an indicator that reflects the number and volume of requests to open buy and sell orders of a certain asset at different prices. DOM allows you to assess liquidity, supply and demand levels, and traders' sentiment.

A deep market is one characterized by high liquidity, where a large volume does not have a significant impact on the price. On the other hand, if it is shallow, a large transaction can lead to an imbalance, causing a rate change towards the trade direction, a spike in volatility (widening price range), and a wider spread. In such a condition, a market maker executes the largest transactions and sets the price range for the day.

Market Depth:

Helps determine potential support and resistance levels based on the accumulation of orders and volumes in a specific rate range.

Shows the behavior of market makers who can influence the price of an asset with large volumes and move the market.

Helps assess the level of liquidity and a change in the width of the spread. The more buy and sell requests, the greater the liquidity.

Indicates a change in volatility and the probable direction of the trend.

Shows the probability of a breakout of key levels.

Helps determine the limit order volume that will not have a significant impact on the rate.

DOM is determined by the number of limit orders to buy and sell organized by price levels and the distance between them.

This concept is quite relative. For a trader with a buy/sell volume of $1 million, such as institutional investors or hedge funds, a total turnover of $100 million is considered shallow. An order with a volume of 1% of the entire turnover cannot be absorbed without significantly affecting the rate because there will not be a single seller capable of covering it. Conversely, a market with a total turnover of $100 million is considered deep for a trader with a volume of $1,000.

Order Book:

The order book is a list of limit pending orders of buyers and sellers at a specific price where data feeds are updated online within fractions of a second.

There are two types of orders in trading:

Level 1 market data (L1): Instructions to execute a transaction on the exchange at the price proposed by the other party.

Level 2 market data (L2): Requests to make a trade above or below the current price.

Please note that only limit orders are displayed in the order book, since market orders are executed instantly. Limit orders are Buy Limit and Sell Limit pending orders. Buy Stop, Sell Stop, Buy Stop Limit, and Sell Stop Limit are not displayed on the external market but are rather processed within the platform.

How the order Book is Formed and Used:

The order books on the exchange and over-the-counter trading are different:

On the exchange market, all requests are sent to the exchange system.

On the over-the-counter market, the order book may reflect quotes generated within the broker's system.

The order book is a list of prices and volumes corresponding to each level. It shows what trade volume must be carried out at a given price level for the quotes to change.

If the market is liquid, there are many instructions to a broker to buy or sell an asset and many response orders, it is referred to as deep.

If there is no liquidity, a large number of orders or a high-volume one left without a response can lead to a significant price change.

How to Read Depth of Market:

Traders pay attention to the following items:

Spread: The smaller, the better.

Size: Counter-order size is crucial for large pending orders.

High-volume requests: Indicates pressure on the price from a large player or the majority of participants.

The ratio of volumes at the top and bottom: Shows the strength of sellers and buyers.

Clusters at certain price levels: These indicate key resistance or support levels.

Conclusion:

The order book on the exchange is an auxiliary tool for developing an optimal trading strategy and analyzing the market condition. Its data helps to:

Assess market liquidity and depth.

Find potentially strong resistance and support levels.

Determine the dominance of buyers or sellers.

The tool has advantages and disadvantages. While it provides valuable market insights, it should always be used alongside other tools like technical indicators and vertical volume histograms to forecast prices more accurately.