When it comes to efficient trading, asset liquidity is of paramount importance. Fortunately for capital market participants, futures offer a wide variety of consistently liquid products.
So how can you identify liquidity in the marketplace? There are many methods, ranging from relying on experience to applying technical indicators. However, one tried-and-true methodology is known as market depth analysis.
What Is Liquidity?
Liquidity is the ability of an asset to be converted into cash. Liquid assets are readily exchanged for cash; illiquid assets are not.
Of course, the applications of liquidity are a bit more complex in the futures markets. Generally speaking, all contracts may be quickly converted to cash. However, the price of this conversion varies according to several factors. The most liquid markets exhibit these attributes:
- Tight bid/ask spreads
- Strong trading volumes
- Orderly price action
- Efficient asset pricing
If you’re an active trader, it pays to engage liquid markets. Liquid markets will provide you with the utmost in trade-related efficiency because prices reflect asset values, spreads are tight, and volumes are consistent. Now, let’s take a look at how traders use market depth analysis to identify inherently liquid securities.
Applying Market Depth Analysis
Perhaps the best way to measure a product’s liquidity is through a study of its market depth. Market depth is the total number of buy and sell orders local to a security at any given time. Think of market depth as the checkout line at a grocery store―the longer the line, the greater the market depth. Deep markets are considered to be liquid and ensure that there are ample buyers and sellers at each price point.
Here are three facets of market depth analysis that are used to identify liquidity:
- Order flow: Order flow describes the number of buy and sell orders hitting the market at any one time. Strong order flow is indicative of deep markets, promoting both liquidity and efficient asset pricing.
- Volume: Traded volumes are a basic measure of liquidity. In futures, volumes refers to the number of contracts bought and sold. Traders typically study volume with respect to time period or in reference to a specific price point.
- Depth of market (DOM): The trader’s depth of market, or trading DOM, is a convenient way to monitor evolving liquidity. The DOM is essentially a ladder that illustrates order flow, traded volumes, and price action. For most short-term traders, the DOM is a critical part of order execution as well as analytics.
To many traders, order flow, volume, and trading DOM are vital strategic inputs. A robust order flow guarantees liquidity and produces traded volumes, both of which are reflected on the DOM.
The beauty of this type of market depth analysis is that it is user-friendly and intuitive. You only need to observe the DOM and note the buy/sell orders present at distinct price points. The greater the number of orders, the greater the market depth and potential liquidity.
Getting Started with Market Depth
Among the many benefits of being a modern trader is the availability of technology. Software trading platforms have taken the guesswork out of analytics, specifically as it relates to market depth analysis.
