What is market depth?

Market depth shows the various buy and sell orders that have been placed on the market for a particular security. It is normally arranged in a table of live bid-ask prices with the total number of buyers and volume listed for each price.

Understanding market depth

Market depth is an indicator of volume and provides a real-time snapshot of buy and sell orders for a particular security.

Both investors and traders use market depth to analyze the various prices and volumes that accumulate on either side of the bid and ask price.

Relatively liquid securities will show good market depth, which means large orders will not impact the price significantly.

Relatively illiquid securities have poor market depth and their prices are more affected by large orders.

Market depth is particularly important for traders because it enables them to determine short-term market sentiment.

When sellers outnumber buyers, for example, there is weakness in the price of the security. When the reverse is true, the price of the security is likely to increase.

Information from market depth can also be used to:

  • Determine where one’s order sits in the queue of buyers or sellers and how long they may have to wait before it is filled. An order where the investor sets the specific buy or sell price is called a limit order.
  • Analyze the amount of seller volume to determine whether a market order is appropriate or indeed cost-effective.
  • Determine the point at which the majority of buyer and seller activity is taking place. This can be used to place an order at the head of the queue to ensure it is filled.

Factors that influence market depth

Here are a few factors that influence market depth:

  1. Tick size – the minimum price increment at which trades may be executed. In the United States, the tick size is one-hundredth of a dollar, or $0.01. This was changed in 2001 from one-sixteenth of a dollar to improve market depth.
  2. Market transparency – while bid/ask prices are available most of the time, information about the size of an order or one that is pending is sometimes hidden from view. Less transparent market depth information can cause some investors and traders to refrain from participating.
  3. Available leverage – minimum margin requirements set by regulatory bodies stabilize the marketplace, but they also decrease market depth. In other words, those willing to take on more leverage cannot do so without obtaining more capital.
  4. Trade restrictions – various restrictions prevent market participants from adding depth when they are interested in doing so. Examples include options position and futures contract limits and the uptick rule, which states that short telling is only permitted when a security is on an uptick.

Key takeaways:

  • Market depth is an indicator of volume and provides a real-time snapshot of buy and sell orders for a particular security.
  • Market depth is particularly important for traders because it enables them to determine short-term market sentiment. The ratio of buyers and sellers and their respective volumes may clarify whether there is strength or weakness in the price of the security.
  • Factors that influence market depth include tick size, market information transparency, limits imposed on available leverage, and trade restrictions.

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