Market Depth 101 (2023): What it is, Why You Need to Use it (2024)

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Did you know that markets, just like celebrities, can lack depth too?

Market depth can seem like an old-fashioned indicator in today’s investing and trading landscape, but it’s one of the most common metrics that active and passive traders use every day. Its ubiquity might have taken away its charm, but there are plenty of exciting things worth knowing about market depth.

In this article, we look at what market depth is, how it works, and how to read and use market depth data—regardless of your trading or investing strategy.

Ready? Let’s dive in! 👇

What is Market Depth? 📚

At the most basic level, markets connect buyers and sellers. For example, stock markets like the NASDAQ and the NYSE allow people to buy and sell shares and act as a trusted third party for the trade.

Consequently, markets also allow price discovery to occur—stocks go up and down because of the ever-changing price that market participants are willing to trade them at.

Instead of having a fixed price for every stock, the stock market allows people to select the price of their pending orders. It executes trades when a matching buyer and seller are found (and usually charges a fee for it, although we do live in an era with many leading zero-commission stock brokers today). The price at which the last trade for an asset is executed becomes its market price until the next trade is found.

Since people can choose at which price they buy or sell, it is common for a single stock to have multiple orders at varying price points.

Here’s a basic table that visually demonstrates how this works. Imagine a fictional stock market with only five users, all placing buy and sell orders for the same stock at varying levels. The orders, when combined together, look something like this.

In the current state, this market will unfortunately not be able to execute any trade since the highest-paying buyer is not willing to pay what the lowest-asking seller wants.

Real stock markets like the NYSE have exponentially more trade volume (it is the largest stock market in the world by market cap), and such a scenario is not possible. In this particular case, though, if Seller 2 or Buyer 1 would adjust their price a bit to match, the trade would be executed, and the table would change.

For real-life markets, a similar table exists known as the market depth chart. It combines all the current orders to show an overall view of the order volumes and prices.

The market depth chart allows us to study an asset’s market depth—i.e., asking if there are enough buyers and sellers for the asset and if it could handle large enough orders at the current price levels.

In our hypothetical market with just five people and a total volume of only 110 shares, even a buy order for 30 shares at the lowest asking price would not be fully executed and push the price of the asset higher. This is because the market depth for the asset being traded is exceptionally shallow.

Again, stock markets have many more participants than just five, but market depth is still an essential factor to consider, even for retail traders.

How Market Depth Works 👨‍🏫

Market depth refers to the ability of a market to absorb large enough orders on both sides. While liquidity and volume of the asset are used to calculate the market depth, the terms are a bit different, albeit interconnected.

For example, an asset may have only a few orders within the current price and many orders at a much higher or lower price. While the asset will have an increased number of orders and thus high liquidity, it will not be considered to have market depth since a large enough order can easily swing the asset’s price.

It is literally impossible to manually read through the massive data in an order book (even though you once saw Christian Bale as Michael Burry pretend to do something similar in The Big Short). Fortunately, we mortal investors can use easy tools like a market depth chart.

How to Read a Market Depth Chart 📝

A market depth chart is created using Level 2 data provided by stock markets like the NASDAQ. Yes, there is also Level 1 data, which provides the basic stats like the best bid and ask prices. However, being a savvy retail investor, you are anything but basic.

Level 2 data was first introduced in 1983 and offered statistics relating to the market depth and momentum of the assets. The data includes a list of active orders with price levels and volume, allowing traders to study the market depth of the asset. It is provided for free with almost all stock trading apps today.

Here’s an example of what the market depth chart compiled from the data looks like:

As seen above, a market depth chart shows the buy (bids) and sell (ask) orders. The buy orders are on the left side, and the sell orders are on the right side, with the chart above visualizing the orders.

This allows traders to get a quick overview of the market depth for any asset. In the following section, we explore how retail traders can use this data practically.

How To Use Market Depth For Trading👷‍♂️

Once upon a time, trading information was sent via telegrams, and traders literally had to read through the ticker tapes to evaluate a stock’s price and volume. During that time, the ability to quickly process market depth data was a trade secret, and a modern market depth chart was inconceivable to those early traders.

However, the world would move from analog to digital, and tape reading would become obsolete by the 1970s, and information technology has only gotten stronger. However, there are still some fundamental advantages to processing the information today.

Here are some cases where market depth can be utilized for practical trading purposes:

Identifying Resistance and Support Levels 📊

Finding the Average Buy or Sell Price for Large Trades With Low Volume Stocks 🕵️‍♂️

Market depth data can also be helpful when contemplating entry and exit points for your trades as you have a total overview of the orders pending on the market. For example, if you are trading stock with low volume and want to buy many shares, the market depth data can allow you to guesstimate the average buying price. Or conversely, the average sell price in the opposite scenario.

Estimating Where the Price for an Asset Might Be Heading

Although a straightforward and basic technique, market depth charts can be used to get a quick idea of where the price of an asset might be heading. While we would recommend using more sophisticated tools and techniques to speculate prices, market depth charts offer a quick way to understand any asset’s price action and trading volume.

Where Can I Find Market Depth Data? 🤔

Market depth data can be a bit like salt—we barely notice it in our day-to-day lives, but it can matter a lot if it’s missing altogether. As it happens, not all brokers and stock analysis software provide market depth charts. This is also the case with national stock exchanges—like the situation in 2018 in Nepal when traders learned their new trading system couldn’t display market depth data due to tech issues.

Fortunately, there are several sources to get accurate international market depth data for almost any asset you can think of. For example, Interactive Brokers comes with real-time data feeds from markets worldwide. However, most premium stock trading or analysis apps should also offer market depth.

Factors That Influence Market Depth 📃

Multiple factors affect the market depth of an asset. While the buy and sell orders are major factors in ascertaining the market depth, they are not the only thing that matters. Here are some of the order factors at play when it comes to market depth:

Trading Regulations 🛡

For massive markets like the NASDAQ, there are several regulations that all participants must comply with. These regulations can halt trading in case the price of an asset goes above or below a specific price point. Since the range of possible prices is limited and defined, the market depth is concentrated within the two bounds.

Additionally, traders also have to deal with margin requirements and trading restrictions which further constricts traders’ ability to manipulate the market beyond natural reason.

Tick Size 📈

Tick size refers to the minimum increment in price that an asset can move in the market. With more precise tick sizes, the market depth of an asset can be increased as both buy and sell orders will be closer together.

Lack of Precise Data 📂

Conclusion 🚩

Market depth is a light concept but with heavy implications. Therefore, learning about market depth and other stock analysis techniques is vital for retail traders looking to gear up their skills to the next level.

Now that you know how market depth works and how it can influence your trading, it might be a good idea to look at how it relates to the other essential aspects of the stock market.

Get Started with a Stock Broker

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.