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Liquidity & the DOM

We have seen how a Footprint chart provides us with the data of the volume that has traded on either side of the market at each price level. This represent trade that has happened and allows us to understand supply and demand that has transacted. Traders have committed their position through the act of trading.

The Depth Of Market (DOM) price ladder showing the quantity of limit orders at each price level displays the advertised intentions of traders to trade at given prices. Of course, this information changes millisecond to millisecond as orders are stacked and pulled on each side of the market as intention to trade changes.

We pay more attention to the traded volume data recorded in the Footprint than the liquidity in the DOM as it represents committed trade rather than intention (real or otherwise…) to trade. While ‘spoofing’ – placing and pulling of orders – is prohibited by exchanges, as large traders work their orders into the market they will of course add liquidity to the market to enable them to fill their position.

An institutional trader working a buy order for 10,000 contracts into the market on behalf of a commercial client, you cannot simply purchase 10,000 contracts at market. Your intention will be visible and there is unlikely to be sufficient liquidity available to enable your purchase of this size at the desired price, so the order must be worked into the market.

The trader (or their trading algorithm) will be tasked with buying 10,000 contracts over a short period of time within x% of that time period’s volume-weighted average price (VWAP). To do this, they may place an ‘iceberg’ order (an ‘hidden quantity’ order that does not display its full quantity to the market but replenishes the partial quantity displayed as this partial quantity is filled) to buy, e.g. ‘Buy 10,000 at 52.36; display quantity 500 ± 20%”. While this iceberg order is working, they may place sell orders above the market. This has several effects. The presence of the large sell orders may convince some traders that there is a large seller above the current market price. These traders will think they have an opportunity to front-run the selling and will sell at lower prices than the sell order levels. In fact, they are selling to the trader that wants to buy! The trader buying the large quantity is not spoofing however! As the market moves up and down, so long as they sell less volume than they have purchased, they are still slowly building up their long position and may in fact be improving on their average purchase price by selling small quantities at higher prices while they replenish larger quantities at lower prices. Once they have achieved their objective of buying 10,000 contracts they will pull the remaining sell orders. This is how and why markets move between price levels in different timeframes. Large volume moves the market but takes time to accumulate and distribute.

Uninformed traders regard the presence of an iceberg order as a significant event or threat. We can identify an iceberg order both by reading the DOM liquidity and also considering the relationship between traded volume and price. We cover this in the Absorption section.

While it is important to have an appreciation of liquidity, it is traded volume that tells us where traders are positioned. Various trading platforms incorporate methods to visualize current and historic liquidity that allows us to track price levels where liquidity was large or small.

sierra chart market depth historical graph bookmap

So long as we remain aware of whether liquidity is increasing or decreasing at a given price level, we are equipped to fine tune our reading of how the market is reacting right now to the volume that has traded historically.

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