What is Market Depth?
Market depth refers to a market’s ability to absorb relatively large market orders without significantly impacting the security’s price. It encompasses the level and breadth of open orders, bids, and offers, typically for individual securities. Essentially, the more buy and sell orders present, the greater the market depth—especially when these orders are evenly distributed around the current market price of that security.
Key Takeaways
- Market Liquidity: Market depth reflects a security’s liquidity based on the number of standing buy (bid) and sell (offer) orders at different price levels.
- Volume Insights: It also assesses the volume or size of orders at each price level.
- Impact of Large Trades: Higher market depth means lesser impact on a security’s price by large trades.
- Order Book Visibility: Market depth can be gauged through level 2 price quotes available in a security’s order book.
The Importance of Market Depth
Market depth—or depth of market (DOM)—is deeply tied to liquidity and volume in a security, although a stock with high trade volume doesn’t necessarily have great market depth. Market depth evaluates the open order book containing pending buy or sell orders at various price levels. Even high-volume stocks can experience volatility if large enough order imbalances occur on a trading day.
The introduction of smaller tick sizes on major U.S. exchanges has reportedly improved overall market depth by diminishing reliance on market makers, who historically countered order imbalances.
Market depth derives from the accumulation of all orders in a security’s order book at any point in time. It represents how much can be traded for a limit order at a given price (without size limit) or the best possible price achievable by a market order of a specific volume.
Deep markets imply a balanced, substantial volume of bids and offers on both sides, preventing large orders from drastically moving the price.
How Traders Utilize Market Depth Data
Traders leverage market depth data to anticipate price trends for securities. It aids in understanding the bid-ask spread and accumulating volume above bid and offer figures.
Securities exhibiting strong market depth typically have high volume and liquidity, enabling traders to execute large orders with minimal market price impact. Conversely, securities with poor depth may face significant price adjustments with sizeable trades.
Modern trading platforms provide real-time market depth data for free, presenting a comprehensive list of pending buy and sell orders categorized by price level, helping traders gauge the market landscape more accurately. This capability is particularly exploited during periods of high volatility or events like when a firm goes public, indicating strong buying demand potentially pushing prices higher.
Example of Market Depth
Consider an order book reflecting the current bid-ask spread and market depth details. For instance, MEOW shares might have quotes as follows:
- Current Quote: $13.62 (bid) - $13.68 (offer)
- Bid Volume: 3,000 shares
- Offer Volume: 500 shares
Suppose all 3,000 shares are sold at the bid price of $13.62; the subsequent best bid is $13.45 for only 16 shares. If an order to sell 10,000 MEOW shares is placed at market price, the sale would span down to $13.35, acquiring 43,500 shares at that level. This movement demonstrates a market depth deficiency as it results in a price drop by approximately 30 cents or around 2%.
Understanding and interpreting market depth can offer critical insights for optimizing trading strategies and anticipating market movements efficiently.
Related Terms: Order Book, Bid-Ask Spread, Market Orders, Depth of Market.
