From the May 2014 issue of Futures Magazine • Subscribe!

Trading with market depth

Market depth is an electronic list of buy and sell orders, organized by price level and updated to reflect real-time market activity. Most of today’s trading platforms offer some type of market depth display that allows traders to see the buy and sell orders waiting to be executed—not just the best bid and ask prices, but the bids and asks on either side of the market—as well as the size of all the bids and offers.

All of this information can be useful to traders because it shows not only where price is now, but where it is likely to be in the near future. Here, we look at market depth, from the basics to how you can add market depth to your trading toolbox.

Inside prices

Market depth displays information about the prices at which traders are willing to buy and sell a particular trading symbol at a single point in time. Market depth data are also known as Level II, depth of market (DOM) and the order book since it shows pending orders for a trading instrument.

Because market depth is in real time, it changes constantly throughout the trading session. On an instrument such as the E-mini S&P 500 futures contract (ES), which trades under extremely high volume, the market depth updates many times each second. On thinly traded instruments, the bids and offers may update every few seconds, minutes or even hours.

Regardless of how frequently new bids and offers come to the market, market depth shows the different prices and the number of orders lined up at each price to buy or sell.

Market depth data can be viewed on a separate Level II window or on a price ladder and shows the buyers (bid) and the sellers (ask). (Note: U.S. regulations require that bid prices always appear on the left and ask prices appear on the right.)

A price ladder or DOM display shows each price level in the middle column, with the number of buyers at each price level on the left, and the number of sellers at each price level on the right, as shown in “Climbing the market” (right). 

Another way to view market depth is to overlay it on a price chart, as shown in “Charting depth” (right). These are the same data that would appear on a Level II window or DOM, just presented in a different, more visual manner. In this example, the levels of market depth are displayed over the right-hand side of a price chart, next to the various prices.

The green bars represent the buy orders; these are called the bid prices. The size of each green bar reflects the relative number of shares, contracts or lots that buyers would like to purchase. The vertical location of these bid bars correlates to the specific price at which traders are interested in buying. The top green price bar is known as the inside bid and represents the highest price at which there are interested buyers. This can be thought of as the wholesale price for the symbol.

The red bars indicate market participants who want to sell; these are known as the ask prices for the symbol. The size of each red bar reflects the number of shares, contracts or lots that traders would like to sell, and the vertical location corresponds to the specific price at which traders are currently interested in selling. The lowest red bar is known as the inside ask and represents the lowest price at which there are interested sellers, or the current retail price for the symbol.

This market depth display also displays numerically the size of the bids and asks at each price level. For example, there are 1,515 contracts for sale at the price of 1880.00. It also shows the cumulative activity: the total number of buyers (shown as a total and as a percentage beneath the bid bars) and sellers (shown above the ask bars). 

Regardless of how market depth is viewed, it provides information about the inside bid and ask — the price at which you could buy or sell right now with a market order—as well as multiple levels of bid and ask prices waiting in the queue. 

To simplify how market depth works, it might be helpful to see how the display changes when a trader places an order. “Order up,” right, shows two DOM displays. The one on the left shows an inside bid of 1634.50 with a size of 153. Imagine a trader places an order to buy 10 contracts at this level. The size at 1634.50 immediately increases to 163 (see the DOM on the right), reflecting the order to buy 10 contracts. In this manner, the market depth changes continually throughout the trading session as buyers and sellers place their orders in the market, and the orders are either filled, modified or canceled.

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