Perceptions of Market Depth:
Here are a few thoughts and observations I've had regarding the use
of market depth as a daytrading tool. I see this forum as the
perfect opportunity to bounce ideas off one another. I'd welcome
an active discussion of this topic so that all may benefit.
I've seen many a post that makes reference to either "good", "bad",
"strong", "weak" depth, etc. Of course, the interesting part is
to watch the price action evolve from that particular point in time
going forward. Allow me to present and discuss four basic scenarios
that we've all seen before in actively traded stocks. I've created
my own names for them. Hopefully they'll suffice for the discussion.
Strong Depth:
Bid Ask
#Ord #Sh Price Price #Sh #Ord
--------------------------------------
1 20,000 19.95 20.00 2,000 3
3 15,000 19.90 20.05 1,000 1
2 10,000 19.85 20.10 2,000 2
5 25,000 19.80 20.15 5,000 6
8 20,000 19.75 20.20 4,000 1
Weak Depth:
Bid Ask
#Ord #Sh Price Price #Sh #Ord
--------------------------------------
1 500 19.95 20.00 20,000 3
3 1,500 19.90 20.05 10,000 1
2 500 19.85 20.10 15,000 2
5 2,000 19.80 20.15 20,000 6
8 5,000 19.75 20.20 20,000 1
Log-Jam Depth:
Bid Ask
#Ord #Sh Price Price #Sh #Ord
--------------------------------------
1 20,000 19.95 20.00 20,000 3
3 15,000 19.90 20.05 10,000 1
2 10,000 19.85 20.10 15,000 2
5 25,000 19.80 20.15 20,000 6
8 20,000 19.75 20.20 20,000 1
Mixed Depth:
Bid Ask
#Ord #Sh Price Price #Sh #Ord
--------------------------------------
1 4,000 19.95 20.00 20,000 3
3 15,000 19.90 20.05 2,000 1
1 1,000 19.85 20.10 3,000 2
5 10,000 19.80 20.15 10,000 6
2 2,000 19.75 20.20 5,000 1
Subsequent Price Action:
========================
Strictly from a day-trading perspective (time-frame of trade is
intra-day) I've noticed very interesting patterns with regards to
how market depth is perceived by the trader and subsequent price
action. Daytraders are looking for potential price movement in
either one direction or the other. I've found that two of these
scenarios, namely STRONG and WEAK depth, are good indicators of
future price action, whereas the LOG-JAM and MIXED depth scenarios
are poor indicators.
1. STRONG depth tends to be a point at which the price is readying
itself for significant deterioration.
2. WEAK depth tends to be a point at which the price is readying
itself for significant improvement.
3. LOG-JAM depth tends to be a point at which the price is simply
stuck.
4. MIXED depth tends to be a point at which the price may fluctuate
a little but is not ready to make a significant move one way or
the other.
STRONG depth indicates that demand is strong. This is generally the
point in time at which it pays to sell...before supply emerges. How
many times have you seen a stock with next to no offers all of a
sudden reverse direction to the downside? Conversely, WEAK depth
indicates that supply is strong. This is generally the point in time
at which it pays to buy...before demand emerges. How many times
have you seen a stock with next to no bids all of a sudden reverse
direction to the upside? LOG-JAM and MIXED depth scenarios indicate
a relative balance of supply and demand. This is generally the point
in time when it doesn't pay to have a position at all.
In scoping the prospects of a daytrade I find it useful focus my
attention more on situations #1 and #2, and keep situations #3 and #4
on the "back burner". Because depth constantly changes, I wait for
situations #3 or #4 to develop into situations #1 or #2. The process
doesn't stop there though. In focusing on situations #1 or #2 there
may be a number of candidates to choose from. Generally speaking,
the STRONGER or WEAKER the depth, the higher the probability of
making a profitable day-trade.
What the F***?
==============
How many times have the following things happened to you?
1. You refused to take a position simply because the depth was
WEAK, only to see the price move higher. You sit there in
disbelief mulling over a lost opportunity.
2. You sold a position because the depth was WEAK, only to see
the price move higher. You sit there and figure out how much
more money you could have made on the trade.
3. You refused to sell a position simply because the depth was
STRONG, only to see the price move lower. You sit there in
disbelief and figure out how much you could have saved by
exiting the trade.
I'm sure all of us have experienced these situations. Why?
Because the emotional response to market depth is so natural and
so difficult to control.
The Emotional Response:
=======================
Let's assume that the trader is trading from the long side. These
ideas can simply be inverted if trading from the short side.
Depth is perceived as STRONG when it appears that there is plenty
of buying power. Emotionally, the natural response is greed.
The trader either wants to acquire a long position or is happy that
he has one. Depth is perceived as WEAK when it appears that there
is plenty of selling power. Emotionally, the natural response is
fear. The trader either does not want to acquire a long position
or is happy that he doesn't have one. When the depth is either
LOG-JAM or MIXED the emotional response tends to be neutral. The
trader gets a snapshot of relatively balanced power between buying
and selling.
Trading on Market Depth:
========================
I've found it to be very effective to monitor my emotional response
to market depth as a way of gauging when a trade is most likely to
be a profitable one. Specifically, if I'm looking to buy I'll wait
for WEAK depth and a feeling of fear. Conversely, if I'm looking to
sell, I'll wait for STRONG depth and a feeling of greed. It sure
sounds easy, but I sincerely believe that this is one of the most
difficult things to do in daytrading. Let's face it, you're fighting
your most natural impulses. To me it's no different than trying not
to blink when the optometrist blasts that puff of air into your eye.
Even more difficult is to try and catch yourself rationalizing a
position when market depth is clearly telling you that you're on the
wrong side of the trade.
If anything, it's a tremendously interesting exercise to watch the
market depth in a selected equity with the above concepts in mind.
I do this constantly...I watch the depth and make "paper trades" to
make sure I'm on the right side of the market on any particular day.
Anyway...I'm starting to tire a bit here. As I mentioned before, I'd
welcome responses to the above. However, I'm sure that Chief and
others on this thread would appreciate that lengthy discussions on
this subject be left for non-market hours.
Adios for now.
WN |
