Last Updated on 7 April, 2022 by Samuelsson
Traders always look for ways to improve their edge in the market, and one of the ways they do that is to monitor the order flow in the level II order window, which is also referred to as the DOM. By monitoring the size and tendency of the order flow, traders can anticipate the likely direction of the market in the near future and use that to their advantage. You may be wondering what DOM is.
Depth of market (DOM) is a measure of the supply and demand for liquid assets. It depends on the number of open buy and sell orders for a given asset such as a stock or futures contract: the greater the quantity of those orders, the deeper or more liquid the market is considered.
In this post, we will tell you what you need to know about DOM trading. To do that, we will explore the topic under the following subheadings:
- What is Depth of Market (DOM)?
- How does DOM trading work?
- Who needs DOM?
- Factors that affect the DOM
- DOM trading example
- What do you want to write here?
- Advantages of DOM trading
- Disadvantages of DOM trading
What is Depth of Market (DOM)?
Depth of market, DOM for short, is a measure of the supply and demand for liquid assets. It depends on the number of open buy and sell orders for a given asset such as a stock or futures contract. A market with a huge number of orders lying in wait is considered highly liquid. It shows the market’s ability to absorb huge market orders without affecting the price of the asset significantly.
DOM tells traders the overall level and breadth of open orders, bids, and offers available for an individual security. Generally, the more the number of buy and sell limit orders in the market the better the depth of the market, provided the orders are fairly distributed around the current market price of the security.
Since the DOM consists of a list of pending orders for a security, it is also known as the order book. Traders use the information in the book to determine which transactions are likely to be processed and which direction the market may head in the immediate future. Most online brokers provide the DOM data on their platforms for free or for a small fee.
How does DOM trading work?
The Depth of Market (DOM) is available as a window that shows the market activities that take place at various price levels of an asset in real-time. It 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 indication of liquidity, showing the supply (buy orders) and demand (sell orders) of a security. 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. So, traders use it to gauge the number of shares of the asset that can be bought without causing its price to appreciate.
For example, a very liquid stock is one that has a huge number of buy and sell limit orders lying in wait at close levels in the market. Therefore, a buyer can easily purchase a large amount of liquid stock without causing a significant shift in its market price. However, if a stock does not trade consistently due to low liquidity, then purchasing a block of such stocks may have a noticeable impact on the stock’s price as the available orders in the market are far apart from each other.
Therefore, it helps traders to see the buy and sell orders organized by their price level and updated in real-time to reflect current market activity, which they can use to improve their trading decision. You can easily see some form of DOM in most online brokers, and they are designed to allow users to see the full list of buy and sell orders pending execution, along with the size of the trade, rather than just the best options available.
By measuring real-time supply and demand, traders use the DOM data to assess the likely direction of an asset’s price in the near future, as orders are filled, updated, or canceled. A trader can also use market depth data to understand the bid-ask spread for a stock, along with its current volume.
Being able to view the depth of market information for a particular security in real-time allows traders to profit from short-term price volatility. For example, when a company launches its initial public offering (IPO), traders can watch its DOM in real-time, waiting for the opportunity to buy or sell shares when the price reaches the right level of demand.
Who needs DOM?
The depth of the market is highly useful for the retail traders as it helps them to correctly wait for large contracts to enter and get as close to them as possible, and then carefully follow the trades of the more significant traders.
The idea is that market prices are largely determined by substantial volumes of orders, which inevitably come from large players.
The best strategy for small traders is to follow the actions of a significant player who can change the market’s movement at any time.
Factors that affect the DOM
1. The tick size
This refers to the least amount that an asset’s price could move. In a situation where the tick size is too small, there will be a smaller incentive for market makers to post orders in advance since others are able to go ahead of them by posting orders with little price difference.
However, if the tick price becomes large, traders would be encouraged to prioritize by posting orders in advance. Thus, an appropriate tick size is important to balance the DOM.
2. Minimum margin requirements
The minimum margin requirements often determine the amount of leverage that is available to an investor. High margin requirements would likely lower the market depth because parties participating in transactions cannot make large orders without that much capital.
3. Restrictions placed on price movements
In various financial markets, the prices of assets are somewhat restricted to some extent, limiting random price changes by exchanges. For example, the futures contracts for some assets are subject to fixed and variable price limits. This price restriction helps to increase the market depth.
4. Trading restrictions
There are several other trading restrictions, including the futures and options position limits established by the U.S. Commodity Futures Trading Commission (CFTC), that help to limit the maximum amount of shares or contracts that an individual can earn. These restrictions can prevent individuals from unfairly controlling the market.
5. Level of transparency in the market
Transparency is an important factor that influences the market. While most participants in the market can access much of the information on the market, there are still several pieces of information that are not available, including the pending bid and offer prices. The transparency of a market can cause concerns to participants and impact their willingness to post their orders.
DOM trading example
The DOM can help traders to estimate and determine the immediate price change. Let us see an illustrative example to demonstrate this:
Let’s say a stock is currently trading at $40.00, and above the current price, there are 290 pending offers at the price of $40.05, 2100 offers at $40.10, and 160 offers at $40.15. Below the current price, there are 170 offers at the price of $39.95, 85 offers at $39.90, and 45 offers at $39.85.
Taking a careful look at the trend above, there is a strong indication that the stock’s market price is more likely to go up as the market tends to track towards a larger pool of orders. A trader can easily take a cue from this information offered by the DOM to determine whether or not it is the right time to buy or sell the stock.
Let us also see another DOM trading example. Say a trader is tracking the DOM of Stock X. The shares might currently be trading at $1.00. But there are 50 offers at $1.05, 400 at $1.08, 10 at $1.10, and $1.12. Meanwhile, there are 250 offers at $0.98, 250 offers at $0.95, 130 at $0.93, and 125 at $0.92.
Looking at the trend in the second example, the trader can discern that the stock X is likely to fall in the immediate future. The above knowledge could help the trader to determine the right time to buy or sell the stock.
Advantages of DOM trading
DOM trading offers many benefits to traders. Most traders argue that DOM is the most useful tool compared to other technical analysis tools, and this argument is as a result of the following reasons:
· DOM data helps traders determine where the price might be going to. Consider a situation where the data reveals that the bid side liquidity exceeds offer side liquidity. This could indicate a bullish trend for the currency pair. Conversely, if offer side liquidity exceeds bid side liquidity, it could be a bearish indicator.
· Some traders who use scalping strategies use DOM data to help them determine when they should enter in and out of positions. DOM data is particularly useful to those who scalp as technical indicators, and candlestick charts tend to be less reliable over shorter time frames. Very few traders base their short term trading decisions solely on DOM data and instead use DOM data alongside technical analysis and other trading tools
· DOM trading allows traders to see the liquidity at each price level. The depth of market functionality is particularly useful for those who are placing very large trades as it allows them to see the expected entry price instead of the quoted spot price.
· DOM shows several contracts at each price, who is currently driving the market, buyers or sellers, or if the market is balanced or merely inactive.
· It displays incoming orders for transactions whose execution will not be affected by non-pricing. This also shows where the largest volumes are located and helps analyze liquidity imbalances. In other words, it shows the level of an excess of demand over supply and vice versa.
Disadvantages of DOM trading
For DOM to work, a trader must understand whether he has enough capital and leverage to influence the price so that he can reverse the deal at the changed prices.
For example, there are 100 sellers on the market who are willing to sell 1,000 units of an asset for a price in the range of 30-40 dollars.
If you buy 50 units, then by your volume, you will not have any influence on the market, but if you decide to buy 500 units at once, then the remaining sellers, seeing increased demand, will raise the price.
In summary, depth of market (DOM) is a measure of the market’s ability to absorb huge market orders without affecting the price of the asset significantly. The greater the quantity of those orders, the deeper or more liquid the market is considered. 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, you should take the liquidity or DOM of a security into consideration, especially when placing large-size orders. When the market is not sufficiently deep, you 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.