Depth of Market (DOM) is a window that displays the real-time market activity at different price levels in a security or currency market. DOM is also known as the order book. It records the pending buy and sell orders of particular securities, and thus, helps to determine which trade can be made.
Depth of Market (DOM) is organized in a list of prices and shows the numbers of pending buy and sell orders corresponding to each price level.
Traders can forecast whether the price will move up or down through the trend of DOM, and thus, determine the timing to buy or sell.
DOM is impacted by the tick size of a security, allowable leverage, price movement and trading restrictions, and market transparency.
Understanding Depth of Market (DOM)
Depth of market is organized in a list of prices and shows the numbers of open buy orders and sell orders corresponding to each price level. The numbers are an indicator of liquidity, showing the supply (buy orders) and demand (sell orders) of a security.
The DOM measures the sizes of orders that need to be completed in order to move the market to the next price level. The greater the number of buy or sell orders open at a certain price level, the deeper the market is, and more orders need to be executed to move the market price, and vice versa.
Also, DOM informs traders of the number of shares that they can buy or sell without causing price changes. If a market is highly liquid with large groups of buyers and sellers, the market is usually deep, and executing a large order will not cause significant price changes. Conversely, if the depth of a market is low, a large number of orders will move the market price more considerably.
Thus, investors should take the liquidity or DOM of a security into consideration, especially when placing large-size orders. When the market is not sufficiently deep, traders might need to break down a large order into several small pieces and execute each at a different price level. If it is a buy order, the price level will move up one at a time every time a batch of orders is executed; if it is a sell order, the price will gradually decrease. Neither of the cases is favorable to investors.
DOM is mostly used in the currency and security markets. Most exchanges and trading platforms offer such information, either free or for a fee. The list is updated to show real-time pending orders and trade sizes, which allows traders to understand the current market activities.
Application of Depth of Market
Traders can forecast the immediate price change through the market depth. For example, a stock is currently traded at $50.00.
Above the current price, there are:
300 pending offers at the price of $50.05
220 offers at $50.10
150 offers at $50.15
Below the current price, there are:
160 offers at the price of $49.95
90 offers at $49.90
50 offers at $49.85
The trend indicates that the market price of the stock is more likely to move up slightly. Thus, a trader can determine whether it is a good time to buy or sell.
Factors that Impact Depth of Market
1. Tick size
Tick size is the minimum price increment that a security can move. If the tick size is too small, there is less incentive for market makers to post orders in advance, since others are able to go ahead of them by posting orders with little difference in price.
If the tick size is too large, traders are more motivated to take priority by posting orders in advance. Thus, an appropriate tick size is important to balance the DOM.
2. Minimum margin requirements
Minimum margin requirements limit the leverage that an investor is able to take. Higher minimum margin requirements lower the market depth since parties participating in transactions cannot make large orders without that much capital.
3. Price movement restrictions
In many financial markets, security prices are not allowed to move completely free. There are price change limits and trading curbs set by exchanges. The future contracts for many commodities – such as corn – are subject to fixed and variable price limits. Limiting the range that the price can move within increases the market depth.
4. Trading restrictions
Some trading restrictions – such as futures and options position limits established by the U.S. Commodity Futures Trading Commission (CFTC) – cap the number of shares or contracts that an individual can earn. These restrictions can prevent individuals from unfairly controlling the market.
5. Market transparency
Although participants can access much of the market information, there is still information not available – for example, the pending bid and offer prices. The transparency of a market can cause concerns to participants and impact their willingness to post their orders.