DOM (Depth of Market, Level 2, Order Book) – is the current list of buy and sell orders for a particular trading instrument, executed in the form of a special table. It specifies prices, which are currently offered by participants of the exchange market. The market depth shows the current balance between buyers and sellers, and is a useful tool for traders and investors.

The stock market is essentially an auction, where sellers and buyers participate. For example, you decide to buy 10 shares at a certain price, which you set yourself. Your bid falls into the Exchange glass, and if it is close to the current market price, then the seller will be found quickly. If the market wants to buy at a higher price, you will have to wait until the sellers close all the bids above, and then it will be your turn.

What does the Exchange glass look like?

The Market Watch is divided into two columns: the left column shows buyers’ prices and volumes (number of lots), while the right column shows sellers’ prices and volumes. The price difference between the nearest buy and sell orders shows the current spread.

The visual representation of the Market Watch depends on the trading platform used and may differ, but the general parameters are the same. As a rule, sell orders are displayed at the top, while buy orders are displayed at the bottom. The cup cannot contain all requests from buyers and sellers in the online mode. It displays only the bids closest to the current market price.

They, in turn, form the so-called “market depth”. For example, if you use a market depth of 20*20, the Depth of Market will display the 20 closest buy prices and the 20 best sell prices. It is quite common for brokers to display the quotes in the Cup. It can be changed individually using the settings in the trading terminals.

Types of stock exchange orders

Major types of exchange orders:

• Market – is an order for immediate sale or purchase of an asset at the current market price without specifying it. The priority of these orders is mandatory execution: if there is sufficient liquidity in the market, the position will be immediately opened (or closed).
• Limit orders are orders to sell or buy an asset at a specified price. Limit order excludes possibility of transaction at the less favorable price, however it will be executed only if there is an available limit price (or the best), otherwise the order will not be executed.
• Only limit orders are displayed in the Exchange Depth of Market. Bids at market price are not visible here, they are executed instantly at current quotes.

It is quite simple to place limit orders in the Quotation window. To do this, select the desired price (for sale or for purchase), specify the volume and activate the order. You can use “one-click” trading, when required volume is pre-set and a deal is executed immediately with a mouse click on the necessary quote. You can view the executed deals in the Ribbon of Deals (Deal Journal, Level 1).

Bids can be of two types according to their influence on the quotes of financial assets:

• Minor – small orders that separately have no influence on price movement. They can have a limited effect on quotations in case they are grouped in a narrow price range.
• Significant – high volume orders that can strongly influence price movements and attract increased attention of traders and investors.

Another distinctive feature is the iceberg orders that contain visible and concealed parts. For example, 100 lots have been placed at a certain price that is the visible part of the order. At the moment when the requested 100 lots are sold, a new identical sell order appears immediately.

This will continue until the seller has bought out the entire hidden volume, for example 5,000 lots. These bids can be placed under certain conditions but not always. You can track the execution of iceberg bids using the Ribbon of deals.

How the Market Watch is useful for traders and investors

Many experienced investors and traders use the Market Watch as an additional tool for analysis. For example, having found significant support and resistance levels on the price chart, you can try to assess the probability of a price breakout or rebound from them with the help of the Depth of Market.

To do this, look at the number and volume of orders near the price level. If there is a large accumulation of large bids at a significant level, the probability of a pullback from it is high. If, on the contrary, there are few bids and the volume is low, the probability of breakdown of the level is higher.

You can also focus on the bids, assessing them by their “activity”:

• Aggressive – orders that actively move the quotes. They appear suddenly and push the price in a certain direction. Their appearance can be used to assess the direction of the current price impulse.
• Passive – bids that protect a certain price level. These are large orders that stand at a specific price and do not move. Traders often use them to limit risks by hiding protective Stop Loss orders behind them.

Conclusion

The Exchange Market Maker in combination with the Ribbon of deals is a useful tool for traders and investors. The ability to analyze the information presented in it can help to assess the market situation in details. It can be used to confirm the presence of strong support and resistance levels as well as to determine the direction of the current price impulse.

This method can be applied equally successfully on the currency and stock markets, as well as on the commodities market. The most difficult part of this type of trading is the selection of assets.

In this article we will tell you about the basic principles of the paired trading, the basic ways to choose the instruments for it, and give examples of its use in the real market.

What is the pair trading?

Pairs Trading is a trading strategy based on simultaneous trading of two financial instruments that are correlated with each other in different directions.

Correlation is a statistical relationship between two or more values (assets). It may be direct or reverse. In the first case, the price movement of one asset practically repeats all movements of the price of the other asset. In the case of inverse correlation, the charts of trade instruments look mirror-like.

An example of the direct correlation is the behavior of prices of oil and shares of oil companies. When oil prices go up, stocks go up as well. When there is an inverse situation – a drop in prices – the values of these assets will also correlate with each other, but in the direction of the drop.

However, each oil company stock will rise or fall in its own way, some more than others. This temporary divergence in the prices of correlated stocks can be used for pair trading.

The paired trading strategy uses the equilibrium principle according to which periodic divergences of steadily correlated instruments tend to return to their usual average values. Such divergences are most often caused by significant fundamental events (changes in the Central Bank rates, corporate events, etc.).

The essence of the strategy is to identify a pair of financial instruments with a high degree of correlation, one of which has significantly increased or decreased in price relative to the other. After that the overpriced asset is sold and the undervalued one is bought at the same time.

This creates a market-neutral portfolio of two oppositely directed positions whose profitability will depend not on the general direction of the market, but on the price difference between the two instruments. It is expected that after some time the correlation will be restored and the price ratio will return to its previous values, after which both positions can be closed.

How to Choose Instruments for Pair Trading?

The choice of assets for this strategy involves the use of fundamental and technical analysis, as well as statistical calculations. In general, you can start looking for tools for pair trading among:

• Stocks of companies belonging to the same market sector.
• Contracts for similar commodities: Brent and WTI oil, gold and silver, etc.
• Currencies that have a certain correlation.

A popular way to assess the correlation of the two instruments is to calculate the Pearson correlation. The stronger the correlation of assets, the more likely they are to move in the same direction. Also used is such a concept as cointegration – a statistical property of two or more variables that shows the stability of their relationship.

Examples of using pair trading

Let’s look at several examples of using pair trading in different markets.

Stock Market

Pair trading can be used for trading stock indices and shares of companies operating in one or related sectors. From time to time events occur that can lead to violations of the correlation of the prices of such assets, such as the conclusion of large contracts or the development of new products. The general mood of the stock market also has a significant impact on the quotations.

Commodity market

For paired trading you can take contracts on similar commodities, such as oil and natural gas, gold and silver. It is also possible to use different types of contracts for the same commodity.

Forex currency market

In Forex, for pair trading, you need to choose two similar currency pairs. For example, EUR/USD and GBP/USD have a positive correlation. But this correlation is unstable, which is why pair’s charts can diverge by a very large distance and not converge back for a long time. In fact, trading EUR/USD and GBP/USD spread is similar to trading their cross – EUR/GBP. When there is a steady trend in EUR/GBP, the EUR/USD and GBP/USD correlation is broken.

Risk Management in Pair Trading

Like any other trading strategy, paired trading requires risk management. Although the position is market-neutral, an unexpected news release affecting one of the traded pair’s assets can drastically change the speed and direction of spread movements. Therefore, it is necessary to formulate criteria for limiting losses in advance.

Since the strategy depends on the change of the spread value, setting Stop Losses for each instrument of the pair will be irrelevant. As an alternative, it is possible to be guided by the total loss on both positions. It is necessary to determine an acceptable amount of risk for the transaction (for example, 3% of capital), and if the total loss on positions reaches this value, close them.

Conclusion

Pair trading is a popular market-neutral trading strategy. It may seem simple only at first glance. To be successful, a trader needs to know how to find appropriate tools, correctly use statistics and choose the best moment for deals.

Also, it is necessary to observe the rules of risk management. Before risking real money, one should test their skills of pair trading on a demo account.

Again, one of the postulates of technical analysis says: “The current trend will continue until it changes its direction”, which pushes us to the fact that any trend will sooner or later end and there will be a change in the trend in the opposite direction. Such a trend reversal we will try to determine in this article.

What is a trend and where does it reverse?

A trend on the financial markets is a directional price movement. In theory, when we see a movement where every subsequent maximum is higher than the previous one and every subsequent minimum is higher than the previous one, we can say that the market is in an uptrend. At this point trends are trying to buy, because the current trend is more likely to last than to change its direction.

Consequently, if a bullish trend reversal is expected, it is important for us to make the next maximum lower than the previous one, and the new minimum will also be lower than the previous one. At this point we can assume that we are about to see a trend change in favor of the downtrend. Here it is important to think about selling the financial instrument.

If we see during the price movement that every subsequent minimum and maximum is lower than the previous one, then we are in a descending trend. If we talk about an attempted reversal of this trend, it is important to see the moment when the next minimum will not be updated, and the prices will break the maximum, it will be a simple signal of a potential reversal in favor of the uptrend.

As we can see, the very reversal of any trend is in the nature of price behavior in the market. However, traders rarely focus only on price movements, more often they add various tools for better detection of reversals.

Instruments for Detecting Trend Reversals

Experienced traders advise to look for trend reversal signals on daily charts. In general, you can try to do it on smaller time intervals, but it should be remembered that in this case the reversal is more likely to be short-term, because the main trend is better to determine on the daily chart.

The easiest way to determine the reversal is to break the trend line. If the trend is ascending, here we draw an ascending trend line using the minimum points and wait for the breakdown of this line. More often than not, the breakdown of such a trend line is followed by a return and a test from the opposite side, after which prices move further down.

In case of a downtrend, the line is plotted on the maximum points and it is important to wait for prices to fix above this line, so we can talk about the change of the downtrend in favor of a bullish trend.

The next variant is breakdown of the channel’s border. The construction of such channels is somewhat more complicated than a simple trend line, but the essence is similar to the breakdown of the line: here we wait for the price to go out of the channel, and at this point a trend reversal is formed. And many authors postpone the width of the channel in order to determine the potential for further price movement.

Chart traders also like to identify such moments with the help of trend reversal patterns. For example, “Head & Shoulders” or “Double Bottom” pattern, “Diamond” pattern can act as a reversal pattern. These are simple patterns, but there are some subtleties which are important to observe in their correct search and identification on charts, because only if used correctly they are able to give good reversal signals.

Will Moving Averages help?

Almost any trend indicator can be tuned to a specific instrument and try to look for the end of a trend. If we consider the moving averages, which are one of the best indicators to determine the trend on the market, of course they will also help with this task.

It is important to remember that moving averages will lag a lot. Therefore, we will get a signal to end the trend when another trend is in full swing. However, many investors think this is insignificant and if the new trend is strong, the part of the missed profit will be less than the potential profit from a good trend.

Moreover, this indicator will give signals in the direction of the trend, and we will be able to hold positions and add new ones as long as possible. There is also an opportunity to get a confirmation in the form of prices returning back to the moving averages after the start of a new trend. Such a return will give an opportunity to enter in the direction of the trend with less risk.

However, unfortunately, the Moving Lines are of no help in detecting a reversal at an early stage. On the other hand, they can tell us that the current trend is slowing down and losing its strength, the moment the lines begin to converge after a strong divergence. This we can easily notice and look for confirmation for the beginning of a trend reversal.

How to catch a reversal using patterns?

This is probably one of the best options for entering the market when a trend ends with minimal risk. If you, as a trader, like to analyze the chart and follow the price, then this method is perfect for you. Any of the presented patterns is able to give a good point of entry into the market when it is just forming, the whole risk of such a trade will be to enter as close as possible to the upper or lower point of the pattern.

If we’re talking about Double Top pattern, it’s important to enter the trade when the second resistance level is formed, and place the stop above this area. If the price moves in our direction, we can add a position when it breaks the support level, as the followers of classical technical analysis would have us do. In the case where the price continues to rise, we exit the market with minimal losses.

Here we need to be proficient with these tools and understand when to exit the market, if the prices go against us, because the trend in this case continues and the desire to wait out the current movement can result in huge losses.

At the same time, with the help of patterns we get an opportunity to enter the market at an early stage of the current trend’s end. This is one of the main advantages of graphical analysis. The nature of patterns formation and the market trend itself are closely related, and we react exactly to the price fluctuations, and not to the result of these movements processing, as in the case with indicators.

Divergence is a good signal for reversal

Alexander Elder singled out the “Divergence” signals on the MACD indicator as one of the strongest ways to reverse trends in technical analysis. Indeed, we can observe the strength of this signal on the daily charts, where such “Divergences” can provoke the development of serious corrections. Here it is also quite simple to enter the market: when the signal line leaves the histogram area, we sell, if the signal is formed above zero.

If the trend is downward and the signal is formed below zero, the signal line exit from the histogram area will be a signal to buy a financial instrument. However there are subtleties in using this method: we don’t always know where this signal may end up. Sometimes there are “Double Divergences” when the price moves even lower and the signal on the indicator remains relevant. In this case, we have to hold the position, but the risks of loss are greatly increased.

Conclusion

We can use simple technical analysis tools such as trend lines, channels and reversal patterns to determine the reversal, or we can add trend indicators, but get lagging signals. Several methods can be combined for a better result. For example, forming a “Divergence” on the MACD indicator and as a confirmation trader waits for a breakdown of the trend line, and only then enters against the main trend. Thus, we get already two signals to the end of the current trend, which significantly strengthens our position.