What is Depth of Market (DoM)? A Trader's Guide | LiteFinance (2024)

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.

In this review, you will become familiar with the concepts of market depth and order book, learn how to determine the liquidity level using the latter tool in MT4, MT5, and cTrader platforms, and learn how large traders manipulate the asset’s quotes.

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. Based on the number and volume of instructions to execute a trade placed, you see price ranges with lower and higher liquidity. Its decrease indicates a possible widening of the spread and that even a relatively small can significantly affect the quotes.

• Indicates a change in volatility and the probable direction of the trend. An increase in the frequency of orders in both directions indicates an increase in volatility. The predominance of volumes and orders in the same direction indicates the direction of the trend. If the buy or sell orders significantly predominate but there are no counterparties for them, this may indicate the formation of an upward or downward trend.

• Shows the probability of a breakout of key levels. The trader determines key levels based on previous extremes and assesses the probability of a breakout of the resistance or support level. For example, if a trader sees a sharp increase in the number of buy limit orders and a decrease in sell limit ones, this may indicate that a strong bullish trend and a breakout of the nearest resistance are likely.

• Helps determine the limit order volume that will not have a significant impact on the rate. If there is no liquidity, a pending order with a large volume will cause an imbalance.

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.

Key Takeaways

Order book

Let's take a closer look at the term "order book." What is it, how is it used in trading and how can you find it on the trading platform?

Order book and its analysis

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 or L1. These are instructions to execute a transaction on the exchange at the price proposed by the other party. A buyer sees an offer to sell an asset at $100, accepts the offer, and places a counter bid to purchase the asset. Such a request is then immediately fulfilled. The instruction is only canceled if there is insufficient stock available. To illustrate, you want to purchase 10 lots of an asset, but only 8 lots are available at the price of $100. In this case, the order is partially fulfilled or not fulfilled at all.

• Level 2 market data or L2. These are requests to make a trade above or below the current price. For example, you see an offer to sell an asset at a price of $100 but do not accept it. You place a pending order to buy at $95 and wait for the rate to fall. Thus, it is displayed in the order book.

Please note that only limit orders are displayed in the order book, since market orders are executed instantly. If the pending order disappears from the book, it means that the price has reached its level and the request has been fulfilled. 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. Therefore, as a rule, they are not displayed on the list.

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. Therefore, the list includes real prices and volumes.

• On the over-the-counter market, the order book may reflect quotes generated within the broker's system. The trader does not see real volumes that affect the price. They only see the broker's internal information.

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. The more buy or sell transactions and the greater their volumes at a certain price, the more counter orders are needed to change the price.

• 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. Individual large orders without a significant impact on the price are executed.

• 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. Such a condition is referred to as shallow.

You can also track passive and aggressive orders in the market depth. Aggressive ones appear suddenly during sharp price jumps and can cause a breakout of levels. Passive orders, on the contrary, are located near certain levels and form resistance/support. The efficiency of the market depth increases if you add key levels and trend lines to the future strategy.

How to open the order book in MT4 and MT5

There are two ways to open the order book in the MetaTrader 4 and 5 terminals:

Call up the window "View/Market Overview" with the list of assets. Select an asset from the list. Right-click on it and select "Order Book" in the menu that appears.

Press Alt+B.

How to open the order book in cTrader

In the desktop version of this platform, the order book is a separate window located next to the management window. It is located in the DoM tab.

Market Depth Data: The Main Columns

The design of the order book and its functions depend on how trading platforms offer it.

How to read the order book

One of the order book designs looks like this:

This is the simplest interpretation on the MT4 platform. The screenshot was taken from a live account in the BTC (bitcoin) trading chart. The table ​​consists of the following parts:

• The first column is the current prices: the ask price is at the top, the bid price is at the bottom. The best prices are located closer to the middle. The difference between the nearest bid and ask price is the spread. In this case, it is the difference between 42,517.37 and 42,517.36.

• A column with red arrows pointing down: the upper half is for placing a one-click Sell Limit, the lower half is for placing Sell Stop.

• A column with blue arrows pointing up: the upper half is for placing a one-click Buy Stop, the lower half is for placing Buy Limit.

In theory, Sell Limit should be displayed in the upper part, and Buy Limit in the lower part. This is specified in the MetaTrader manual. However, there is a nuance: the order book shows the volumes of transactions for these Limit orders. The column is present in MT5, but not in MT4. You can place pending orders in one click directly from the order book in both platform versions.

The information column between the columns with arrows displays pending limit orders. In this case, Buy Limit (BL) of 0.3 lots was placed at a price of 42,517.28. As soon as the nearest buyer agrees to buy BTC at this price, your trade will take place.

MT4 does not display volumes. This makes the platform's order book almost useless. You see different price levels with the best prices but the exact volume associated with each one is unavailable. Therefore, you cannot identify the potential trend direction, key levels, etc.

In MT5, the developers tried to make the order book more functional:

• Vertical and horizontal volumes have been added. The trading DOM is used to analyze horizontal volumes at a given price. For example, buyers are ready to buy 0.5 lots at 1.07355, and 5 lots at the best bid price of 1.07349. There is also a pending order to buy with a volume of 0.05 lots. The almost tenfold difference between the first and last buyer prices indicates that instructions to a broker are executed almost instantly at the best price, so there are almost no pending orders in the middle of the market depth. It also means that the level at which 5 buyer lots are placed can be a strong support.

• A chart with Bid/Ask prices has been added. It is convenient to monitor the spread.

There is also such an interesting feature in the MT5:

There is a set limit order to buy 1.5 lots, but it is not displayed on the left. The reason is that this is a demo account. On a live account, the placed order will be added to the total trading volume.

You can also use additional scripts and indicators, which are extended versions of the order book in trading. Examples:

• OrderBook. Distinguishes false movement from true movement, determines trading levels with the largest number of stop orders, and so on. Consists of two columns: the first column displays pending take profit and stop loss, the second - traders' transactions that are currently open.

• DOM for MT4. Provides additional information about pending orders and levels. Does not work during high volatility and news releases.

The order book is characterized by the level of depth. A depth of 10×10 will mean that it displays the 10 best buy prices and 10 best sell prices - a total of 20 lines. However, a deep market's high liquidity and instant execution, make such a tool ineffective. In the first 10 lines you will see prices with a difference of literally 1 pip. You will not have time to track price changes. Stock brokers have order books with a depth of 20x20 lines with the possibility of additional expansion upon individual request. The table shows 20 prices on both sides.

How Traders Use Market Depth Data in Real Market Conditions

Using an MT5 trading account, let us examine the application of order book indicators using a simplified yet fully functional tool for gold futures as a case study.

1. The difference between the price of $2,035.47 and $2,035.24 is the spread.

2. There is currently a lack of trading activity, with no bids at all price levels.

3. You are a buyer. Let's consider several options:

   • You want to buy gold in the amount of 70 lots for the long term, so the price is not important to you. You can buy 25 lots at a price of $2,035.47, 25 lots at $2,035.52 and 20 lots at $2,035.53. You have no sellers at other prices. And your contract for 70 lots will move the price from $2,035.47 to $2,035.53. You will absorb the pending volume of sellers and your transaction for 70 lots will be executed at different prices. This is called slippage - the execution at a worse price. For you, with a buy volume of 70 lots, the market is shallow.

   • You want to buy 5 lots of gold. At the $2,035.47 mark, your request will be executed instantly, and the figure "25" in the volumes will change to "20".

   • You want to buy 5 lots of gold at a price of $2,035.49. Your volume will be automatically absorbed by the order at $2,035.47. This is "buying at the best price".

   • You are not satisfied with the best price of $2,035.47. You hope that the price will fall lower and you can buy cheaper. You set a pending limit order at $2,035.22. On the market depth screen, there are no orders at this level and yours will be displayed first in the book. If traders sell 25 lots at a price of $2,035.24, your transaction will be executed next.

You can quickly assess liquidity and slippage by how densely orders are placed in the real-time market, their quantity, and an average spread.

In a deep market with a high data update rate, the numbers in the order book change within fractions of a second because with a spread of several tenths of a point, pending orders find counter ones almost instantly. As a result, the data becomes no longer as informative as it could be. There are three possible solutions:

• Use robots focused on working with the order book. Institutional traders mainly use algorithmic software and neural networks on short-term intervals.

• Ask the broker to increase the depth of the order book if technically possible.

• Switch to assets with a shallow market.

Or learn to instantly analyze information.

Factors Impacting Depth of Market

Both deep and shallow markets have their advantages and disadvantages. It depends on your goals and strategy. Deep markets have high liquidity, so trades are executed almost instantly and at the best price. There is also a narrow spread. At the same time, it offers slower price changes, so there are fewer opportunities to earn and implement trading strategies. In a shallow market, a large limit order can significantly change the price. On the one hand, this is an opportunity to earn money on a trend movement, but on the other hand, there is a wide spread and slippage.

When developing a future strategy, it is better to focus on leverage, trading hours, asset liquidity, possible restrictions, fundamental factors.

Leverage

Leverage can affect market depth both positively and negatively:

• If a trader uses leverage to increase the number of requests and their volumes for trading at different prices, they increase liquidity. Accordingly, market depth increases. The trader's contribution to trading and liquidity is additionally provided by the broker.

• If a trader uses leverage to increase the volume of a position at one price, they thereby create an imbalance in favor of demand or supply. This causes a change in price and an increase in volatility. Accordingly, market depth decreases.

By changing the maximum leverage limit, a broker can indirectly influence the market depth.

Trading Hours

At different times, depending on the type of asset, the market may experience different levels of activity. For example, the EURUSD currency pair showcases the largest trading volume during the US and European sessions. At this given point in time, liquidity is highest, and the market is deepest. During the Asian session, volumes decrease, and the market loses its depth. Another example is a decrease in market depth before holidays and weekends. During this period, most traders consolidate their positions while trading volumes and the number of buyers and sellers decrease.

Asset Liquidity

Asset liquidity is the ability to quickly sell it at the current rate. The greater the liquidity, the greater its depth. For example, assets of developing countries are classified as instruments with low liquidity. Their financial markets are mostly closed, there is little information about them, they are manually regulated. Therefore, they can be considered shallow due to their wide spreads and relatively small trading volumes.

Limiting price movement

This tool is found, for example, in futures trading. Stock exchanges such as NASDAQ and NYSE set price ranges for an asset, thereby eliminating sharp rapid price movements. Traders are forced to place pending orders in a fixed range. The price spread on the list decreases and the market depth increases.

Trading restrictions

For example, in the US, regulators can set limits on the number of shares and derivatives that one person can trade. Limits on the maximum position volume eliminate manipulative influence on the price by market makers and thus do not allow an imbalance to be created in favor of supply or demand.

Fundamental factors, force majeure

This includes any news or a strong fundamental factor capable of radically changing the balance of power. For example, there is high liquidity. There are many opening buy orders, and, accordingly, there are counter ones. The spread is narrow, volatility is low, and the market is deep.

Then some news gets released, which immediately leads to a sharp increase in buy or sell orders for securities, currencies and other assets. An imbalance occurs, and the market loses its depth. This means that it cannot absorb large volumes of transactions without a significant change in price. Liquidity decreases, the commission increases, as does volatility. One example of a sharp decrease in depth with a change in price is a short squeeze.

On the other hand, fundamental factors can increase market depth. For example, the SEC's approval of applications for spot ETFs on BTC increased the inflow of investor money into cryptocurrencies, thereby increasing their liquidity and depth.

How to Read Depth of Market

Traders pay attention to the following items:

• Spread. The smaller, the better. This allows you to trade on the exchange during highest liquidity. Exit the market when the spread widens.

• Size. If you are going to place a pending order of 10 lots, the size of the counter ones will be of fundamental importance to you. If it is 0.1-1 lot, your position will affect the price and most of your requests will be executed at a less attractive price.

• The appearance of high-volume requests. Allows you to observe the pressure on the price from a large player or the majority of participants.

• The ratio of the volumes at the top and bottom. Shows the strength of sellers and buyers. If there are more buy requests, an upward trend may be emerging.

• Clusters at certain price levels. These are key levels. For example, at the farthest price, buyers form a large cluster. As soon as the sellers drag the price to it, their volume will be absorbed and the price will stop declining.

Please note that the order book does not take leverage into account. It means volumes can be specified with leverage accounted for

Since each platform has its own such tool, do not hesitate to contact the customer support as it may have additional functions that can be activated.

Order book manipulation

The order book and market depth also can become a tool in the hands of market manipulators. One way to manipulate real-time quotes is spoofing. This involves quickly placing and deleting large transaction requests, mimicking market activity and affecting market prices.

Here is how spoofing works. For example, the current market price of a particular stock is $110.80. Imagine that you are a manipulator and want to buy 10 lots at $110.20 to sell it several dozen points more expensive. As a rule, spoofers do the following:

• You place three pending sell orders: 50 lots at $110.65, 80 lots at $110.40 and 110 lots at $110.25. In fact, you are ready to buy only 10 lots, but you have requested your broker to open a sell trade for 240 lots. The goal is to create bearish interest.

• The emergence of a large number of short positions forces participants to place sell orders in the direction of the emerging trend. The price falls to $110.20 under pressure from other sellers. Your transactions remain unexecuted since there is no required volume of buyers on the market. At $110.20, no one is buying the asset at $110.65, $110.40, and $110.25.

• At the $110.20 mark, your buy request for 10 lots is triggered. At the moment of its execution, unexecuted sell orders are immediately canceled.

After they are deleted, it turns out that there is no large seller. Then, in a similar way, buy orders are created, the price goes up and you sell the purchased 10 lots at a higher price. The scheme is most often used in the stock market.

The entire operation lasts less than 1 second and is performed exclusively by algorithmic systems. The spoofer's calculation is that limit orders will be perceived by other robots as a change in trading volumes in the right direction. The price is not moved by the spoofer's orders themselves, but by the market's perception of their appearance in the order book.

In the US, spoofing is subject to criminal and administrative liability. The most famous participants in such investigations are IIgor Oystacher, Michael Coscia, Heet Khara, and Nasim Salim. Other countries are only now beginning to address the issue of spoofing. In theory, spoofing is deliberate price manipulation. However, in the context of high-frequency trading, it can be challenging to prove that an order was placed without the intention of executing it and with the aim of influencing the price.

Platforms for Depth of Market (DOM)

In this section, I will take a closer look at cTrader platform's order book. MT4/MT5 are the simplest trading platforms for beginners, and their books have minimal functionality. cTrader is a professional platform and has an advanced set of tools.

The cTrader order book data is displayed in three windows:

1. Standard display.

It consists of two parts: seller and buyer orders. It displays the price and the amount of liquidity available for purchase and selling at this price. The standard DoM allows you to view the current order book, but does not allow you to open positions from it.

2. Price display.

It is a convenient tool for high-frequency trading. First, you can set limit and stop orders from it. Second, it reflects price details. Sell volumes are on the left, buy volumes are on the right of the price and are colored orange and green, respectively, when you place the mouse cursor over them. Only the current Bid and Ask prices are fully displayed. The remaining prices are represented by the last digits after the dot.

3. Display of the weighted average price.

This is used when trading large volumes and shows the average price for the volume sold. If you work with volumes of 100+, setting a limit order at the price of volumes less than 50 lots will affect the quotes. The values are displayed in real time.

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 the liquidity of the market, determine its depth and spread level. If you want to buy or sell an asset, make sure there is a volume of counter orders.

• Find potentially strong resistance and support levels.

• See the superiority of buyers or sellers by volumes in the order flow.

The tool has its pros and cons. On the exchange, the data is used in many trading systems as a filtering tool and as a source for preliminary analysis of the market condition. It makes sense to use it on short timeframes for scalping, swing trading, and intraday strategies. The tool also has disadvantages: hidden and fake requests, manipulation of volumes by market makers, display of only limit orders. Therefore, the order book should be used with other tools to forecast prices. Namely, with technical indicators, and a histogram of vertical volumes.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.