Ask Colin

How important do you feel it is for day traders to pay attention to market depth, especially depth one or two places down the order?

The simple answer is that market depth is information and day traders, along with other traders and investors should take note of it. The question is how it should be regarded.

Going back to first principles, market depth is simply advertising. Buyers place bids in the market that advertise for sellers. Sellers place offers in the market that advertise for buyers. Trades take place on the market when a buyer or a seller acts on one of these advertisements. This means that market depth is important information. This is especially so for the best (highest) bid and the best (lowest) offer.

In a deep liquid stock, this is where all but the largest traders will be doing business. In less liquid stocks, there may not be enough volume at the best bid or offer. In this case, the trader must consider what volume and prices are available beyond the best bid or offer. In both these cases, the day trader should assess what the balance of supply and demand appears to be and take that into account in making trading decisions.

I said appears to be, because as you will know there are potential buyers and sellers that the trader will not be able to see. There are buyers and sellers who do not place bids and offers in the market. Instead they watch the bids and offers that are made and hit them as they see the prices they are prepared to accept. I have lost count of the number of times I have put a bid or offer in the market in the spread (ie between the best bid and the best offer) and had it cleaned out almost instantly. I have also seen a small quantity available at the best bid or best offer, placed my order at that price for a much larger amount and seen the whole order done very smartly. There are all sorts of reasons why there may be buyers or sellers who do not want to put their orders in the market for tactical reasons. The most common will be that they have a big line to get away and if they disclose it, the market will tend to move away from them. Their purpose is best served by patiently taking up bids or offers that come along. There is nothing illegal, unethical or wrong in any way about this.

As you know there can also be bids and offers in the market where the quantity is undisclosed. The reasons for this will be the same as just discussed in the previous paragraph. Of course it makes life a bit harder for the other participants in the market. However, if they had to disclose their order size, it would put them at a disadvantage. If the market tried to make them disclose their order size, it would just force them to place small orders, wait for them to be taken and then place another small order, so that they can protect their position. This would actually make the market less liquid and less efficient. Think of it like a poker game. I would like to know your hand when I place my bets, but I don't think you would like to show your hand to me.

This brings us to another issue and the second part of your question. This is what does a day trader do about the bids and offers that are away from the spread? Most of these are likely to be legitimate orders. However, some of them will not be genuine. They will be placed by other traders to try to create an impression of supply or demand.

The first thing to understand is that there is a law against market manipulation. This is loosely defined as buying and/or selling shares in order to create a false impression. Usually it will involve buying and selling rapidly to no net effect, or buying and selling through two accounts where the same party owns both accounts.

Placing orders in the market that create an impression of supply or demand is slightly different. A regulator would have a hard time establishing that any given order was not fair dinkum. This is because these orders are legal orders and if you or anyone else decide that you want to accept the bids of offers up or down to these orders, there is no situation in which they would not be executed.

Now, suppose that someone places an order off the pace to create an impression of supply or demand at depth and then cancels it before it gets hit. Again we must ask how a regulator could determine which orders were not real. After all, as just described, they are real. I am sure that if the regulator asked the person why they cancelled the order, the answer would simply be that they changed their mind. There is nothing they could do about this.

I guess that if someone placed lots and lots of orders and always cancelled them, the regulator could mount some kind of case. Whether the law covers this, I am not sure. I think there has actually to be a series of transactions to create a false impression. However, this is something you might like to ask ASIC if it is of great concern to you.

In your extended question, you suggest that you have placed dummy buy orders when you are selling and know others who do it. If you want to play mind games, I guess that is up to you. The risk you run is that the dummy orders could get done and then you will then have even more to sell, Further, you run the risk of breaking the law by creating a false impression, because you will have made an actual transaction in order to create a false impression.

Personally, I am not too concerned about all these mind games. People will always play mind games. If they are playing them with you, then you need to regard potentially misleading orders with great suspicion. My own approach is not to take too much notice of these mind games because it is all too hard. I buy a trend and hold until the trend ends. I am not interested in mind games, only in actual transactions. My time frame is much longer than that of a day trader, but the same principle should apply. If you are trading a short term trend, trade what you see transacted and ignore the mind games, whether they be undisclosed and unplaced orders or what might be dummy orders just off the spread. It is easy to develop a complex that they are out to cheat us. This is not productive in the market or in life. It can be a level of paranoia. The best course is to do the best we can to manage the market as it is.