Analyzing Depth in Financial Markets

Most traders view financial markets on a chart as two dimensional: time and space, aka “distance traveled”. But there is indeed a third dimension too, one that most traders never want to discuss.

That third dimension is depth or “size”.

Not Enough
Unless you are brand new to trading, or in deep denial of reality, you already know that all financial markets are at lowest true liquidity levels since the dawn of online trading. You can see on your charts, on your price ladder, on the time & sales app and within your own real-money trade fill attempts the truth of that fact.

The reason you see all financial instruments flying around, making abrupt v-turn moves in both directions over and over again all day is due to lack of true open interest waiting to absorb future trade orders. Recent volatility from late 2014 into the present time (and likely to continue on) may at times bring greater volume… but volume is not true liquidity. That is where most traders stop thinking, and therefore fail to realize the truth.

If for example for chosen symbol has 500 contracts’ worth of resting orders within a 10-tick price range, that may be liquid enough for everyone to fill during “normal” times when demand matches available supply. But when demand spikes to 1,500 contracts trying to fill and only 500 contracts available inside the same 10-tick range, guess what? Only two outcomes for that buy/sell exchange are possible…

#1: 500 contracts fill and 1,000 contracts do not fill on limit-type orders

#2: 500 contracts fill within the 10-tick range while remaining 1,000 contracts fill outside of the 10-tick range (aka price “slippage” in effect)

No Exceptions
Now I already know what most individual traders are thinking. They think, “this has nothing to do with me… I only trade 1 or 2 contracts so liquidity doesn’t affect me.”

Wrong. Dead wrong.

When 1,500 contracts try to fill 500 resting orders in a given price zone, it doesn’t matter who trades how many or few. That 1 trader who thinks their 1-lot order will always fill thru is no different than the other 999 traders who (mistakenly) believe the same exact thing. So guess what? The market has no personal favorites. All 1,000 of those same 1-lot traders are going to get no-filled on limit type orders or badly slipped on fills outside the 10-tick price range on market type orders.

One or the other… there is no third scenario.

Get In? Stay Awhile? Get Out?
This lack of true liquidity in all popular markets is what keeps price movement ripping up and down and up and down and up and down all day. The directional movement itself can be pretty wide-range and from a purely spatial standpoint, that potential is nice. But from an executional standpoint, getting filled with real money trades and then holding any kind of reasonable stop is the first challenge. After that, exiting for real-money profits before price action abruptly turns and whips back against your position is the next challenge to navigate.

Another true fact in this whole conversation about three dimensional markets? Belief resistance from traders. Nobody wants to think about any added degrees of difficulty to the process. Successful trading is hard as hell already. Just mastering the science of which way to trade and where to get in eludes most aspiring traders, forever. Forever as in they never figure it out in their whole time spent trying. And now we add yet another barrier to entry for success on top of everything else?

So most traders block these facts from their minds, stare at a chart of XYZ symbol and pretend to themselves that trade fills and stop-orders placed will always execute fully on the spot. It’s easier to pretend than it is to deal with the truth in life.

Adjust Or…
Today’s financial markets’ sessions were simply more of the same. Two-way, abrupt and sometimes explosive price bursts… followed by wedged congestion and chop. You either acknowledge, admit, adapt and advance onward, or fall by the wayside. We can all be sure the markets don’t care what path we take, or not.

My solution to thin, illiquid, whippy markets has been demonstrated in these live video chronicles, with one more to complete the series tomorrow. That works for me, it can readily work for you too.

For more daily updates from Austin, visit his blog at Coiled Markets.