The forex market operates on the demand and supply basis, which influences how things work and how prices move. Buyers with a bullish bias in the forex market look to buy the various currency pairs listed on the forex market, while sellers with a bearish bias look to sell the currency pairings.

Individuals or traders must now be connected to the forex market via a forex broker in order to do so. These brokers provide access to the interbank electronic communications network, which underpins the currency market. Traders then submit orders for buying and selling after they have gotten access. Hundreds of thousands of traders from all over the world place orders in the forex markets. They are all trading different currency pairings at different prices. How much detail do the traders see? 

What is the depth of market (DOM)?

The DOM is a tool that displays the distribution of buy and sell orders at various prices for a certain currency pair or securities. It can essentially be used to determine the depth of order liquidity in that currency pair or securities. Although it is impossible to obtain 100 percent real volume data for the Forex market due to its decentralized nature, data from a large liquidity provider or a pool of liquidity providers can be just as useful most of the time.

DOM provides the capacity to see the order flow through the brokerage perspective. In general, a greater number of purchase orders around a specific price level than sell orders can indicate that there is more purchasing pressure in that market, which is positive for the underlying asset or currency pair.

A significant number of sell orders higher than the current market price, on the other hand, may indicate that the market will first bounce up to that level before collapsing when it reaches the exact price level where the huge volume of orders remains. Technical analysis patterns can be implemented with greater confidence using the DOM because a support area confirmed by a large number of purchase orders is a far stronger signal that it will hold than a support area that has not been helped by a large number of buyers.

Calculation

The calculation for market depth is the cumulative volume of the base asset at various percentages from the mid-price. For example, the “Bid Volume 10%” on Coinbase for EURUSD represents the volume of all bids for EUR that are within 10% of the mid-price at which the order book snapshot was obtained. To get the depth, we would aggregate the total volume of all bids placed inside this 10% price range. In contrast, “Ask Volume 10%” refers to the volume of all asks that are within 10% of the mid-price.

Who uses DOM?

This DOM tool is primarily used by scalpers and short-term traders. Because scalpers want to enter and exit the market fast, DOM allows them to find price levels with a high volume of orders. Scalpers would then enter areas with a high volume of sell orders and exit areas with a high volume of buy orders. Short-term traders that try to trade traditional technical patterns can be more confident in their trades. This occurs when the trader notices large orders at crucial price levels, indicating that other traders are in the market using the same research.

Other traders use DOM to discover better pricing to enter trades. They would conduct analysis and look for the best costs attainable. Scalpers and short-term traders can use DOM as a stand-alone tool to take trades, or they can combine it with other types of analysis and methods. The DOM is beneficial to traders who trade with large sums of money. They can use the tool to find a cluster of orders and enter at such levels without incurring slippages and at a low cost.

Uses of DOM

  • Profit is made by exploiting the short-term volatility of the price based on the data.
  • It helps in predicting the direction and magnitude of price change in order to identify whether to buy or sell.
  • It aids in the execution of trading strategies.
  • Its output data can be used to obtain volume and liquidity information.
  • Because it employs trade symbols, it allows for faster monitoring of market activities.

Factors influencing the market depth

Margin requirements

DOM requires minimum margin requirements.  This limits the amount of leverage that a trader can use. Higher minimum margin requirements reduce market depth since transaction participants cannot place large orders without that much capital.

Price movement constraints

Asset prices are not allowed to move freely in many financial markets. Exchanges impose price change limits and trading restrictions. Many commodities, for example, grains and beef, have future contracts with fixed and variable price limits. Limiting the price range within which the price can vary promotes market depth.

Transparency of the market

Despite traders having access to much of the market information, some information is still unavailable, such as the offer prices and pending bids. The lack of transparency of a market makes participants concerned and reduces their willingness to post orders.

Size of the ticks

Tick size refers to the smallest price increment that security can move. If the tick size is excessively large, traders will be more encouraged to take priority by putting orders ahead of time. As a result, selecting an appropriate tick size is critical for balancing the DOM. If the tick size is too small, market makers have less motivation to post orders in advance since others can go ahead of them by putting orders with little price difference.

Conclusion

DOM is a very important tool used by forex traders, especially for short-term transactions. DOM provides supply and demand information for a currency, for example, EURUSD. This helps traders make informed decisions during trading. There are factors that affect DOM, for example, margin requirements of a currency and the size of ticks.

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