Market depth and price bands

4.4

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Remember market depth and price bands? The two concepts that we briefly touched upon in the last chapter? We also said that we would be focusing on them in an in depth manner in this chapter, right? And so, that’s exactly what we’re going to be doing. 

Knowing all about market depth and price bands is extremely essential when it comes to placing an order on the stock exchange. These two concepts have the potential to ultimately decide your course of action - whether to place an order or not, and when to do so.

Market depth meaning: An overview

Also known as the Depth of Market (DOM), the market depth is essentially a metric that measures the amount of liquidity in an asset or a counter. It is used to gauge the demand and supply for an asset like stocks. This is done using the number of buy and sell orders that are currently open for that asset. 

The more the number of open buy and sell orders, the greater the market depth for that asset is said to be. This effectively translates to more liquidity. The market depth for an asset can be easily checked through either the stock exchange’s website or through your own trading portal. 

Generally, as part of the market depth section, stockbrokers and stock exchanges display only the top 5 bid prices and ask prices, along with the available quantity of shares under each price. This is commonly known as level 2 data or 5-depth, because it shows the top 5 prices alone. However, here’s something that you should know. There are also a few stockbrokers who show the top 20 bid prices and ask prices for an asset. This is commonly known as level 3 data or 20-depth.

High market depth: An example

Here’s a snapshot from the NSE’s website showing the market depth for Hindustan Zinc Limited.

As you can see from this picture, the market depth data for Hindustan Zinc shows only the top 5 bid prices and ask prices, along with the available quantity of shares under each price. And at the bottom, you can also see the total number of shares under both bids and asks. Thanks to a high total bid quantity of 3,21,929 and a total sell quantity of 2,50,053, we can come to the conclusion that Hindustan Zinc is a highly liquid stock. 

Low market depth: An example

Let’s now take a look at another screenshot from the NSE’s website that shows the market depth of a stock that’s illiquid.

The stock has a total bid quantity of only 11,202 shares and a total sell quantity of just 1,099 shares. With such low volumes, we can easily come to the conclusion that this stock is very illiquid. Now, if you were to decide to get the shares of this stock, you can only buy 1,099 shares since only those many shares have been put up for sale. Beyond that number, even if you wanted to buy more, you wouldn’t be able to do so until more sellers enter the market.       

That sums up the details on market depth. Now,let’s move on to see what price bands are.

Price bands in trading: An overview

Price bands, also known as circuit limits, are basically lower and upper price limits that are set by the stock exchanges for an asset - be they stocks or indices. The asset is allowed to trade only within the set price band during a trading day. If the price touches either the lower price limit or the upper price limit, then the trading for that particular stock or index is halted immediately. 

These price bands or circuit limits are recalculated at the start of every trading session based on the previous trading session’s closing price. Based on the security and its characteristics, stock exchanges may choose to set a daily price band of either 2%, 5%, 10%, or even 20%. In the case of an index, the stock exchanges usually set multiple trigger limits at 10%, 15%, and 20%.

Price bands in trading: An example

Here’s an example that can help clear things out for you. 

Assume that there’s a stock whose previous closing price is at Rs. 100. Now, in the current trading session, say the exchange has chosen to set a daily price band of 10% for this particular stock.

This would put the lower price limit at Rs. 90 [Rs. 100 - (Rs. 100 x 10%)] and the upper price limit at Rs. 110 [Rs. 100 + (Rs. 100 x 10%)]. 

When the stock opens up for trading in the next session, it would be allowed to trade only within the price band of Rs. 90 to Rs. 110. Now, let’s assume that the price of the stock drops down to Rs. 90. Since the price has touched the lower price band, the stock exchange would immediately halt the trading on that counter temporarily. Alternatively, say that the price of the stock goes up to Rs. 110. Again, since the price has touched the upper price band, the trading on that stock would be temporarily suspended.  

Here’s a snapshot from the NSE’s website showing the daily price band percentage and the upper and lower circuit limits for Hindustan Zinc. 

As you can see from this picture, the daily price band percentage for this stock has been set at 20%. Now, the previous closing price of the stock is at Rs. 262.25. By applying the price band percentage of 20% to the stock’s previous closing price, we get the lower band as Rs. 209.80 [(Rs. 262.25 - (Rs. 262.25 x 20%)] and the upper band as Rs. 314.70 [(Rs. 262.25 + (Rs. 262.25 x 20%)]. 

Significance of price bands

Stock exchanges set price band limits for assets as a measure of protection. These circuit limits help protect the price of the asset from making huge moves on either side, which can disrupt the normal flow of the market and the pricing mechanism. 

For instance, let’s assume that there’s a stock of a company trading at Rs. 200. Now, a news report is released stating that the company’s manufacturing facility is under investigation by the authorities. If the stock exchange doesn’t set any price bands, this piece of negative news can swing the price wildly downward to even Rs. 100 or lower within just one trading session. 

However, with price bands in place, the maximum amount by which the stock can go downward is capped. This prevents the disruption of the pricing mechanism and keeps the flow of the market intact.

That’s not all. Price bands also prevent you from placing an order with an erroneous price. For instance, let’s assume that the price of the stock that you wish to buy is currently trading at Rs. 100. Now, instead of placing an order for Rs. 105, let’s say that you enter the price erroneously as Rs. 1,005. 

If there are no price bands, then the order would get executed at Rs. 1,005, thereby taking the price from Rs. 100 to Rs. 1,005 in just a matter of seconds. That said, with price bands in place, you wouldn’t be able to enter a price that’s more than the upper limit in this case, preventing you from making a costly mistake.   

Wrapping up

So, that’s about it for this chapter on market depth and price bands. In the next chapter, we’re going to be dealing with illiquid assets and what you can do when you end up holding one. 

A quick recap

  • Market depth is essentially a metric that measures the amount of liquidity in an asset or a counter. 
  • It is also known as the Depth of Market (DOM). 
  • The more the number of open buy and sell orders, the deeper the market depth for that asset is said to be.
  • The market depth for an asset can be checked through either the stock exchange’s website or through your own trading portal. 
  • Also known as circuit limits, price bands are basically lower and upper price limits that are set by the stock exchanges for an asset - be it stocks or indices.
  • An asset is allowed to trade only within the set price band in a trading day. 
  • If the asset’s price touches either the lower price limit or the upper price limit, then the trading for that particular stock or index is halted immediately. 
  • Stock exchanges set price band limits for assets as a measure of protection. 
  • They help protect the price of the asset from making huge moves on either side, which can disrupt the normal flow of the market and the pricing mechanism. 
  • Price bands also prevent you from placing an order with an erroneous price.
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