As we have discussed in a previous article, the orderbook is a list of resting limit orders in the marketplace for a particular asset. Market participants are free to either cancel or change their orders at any time based on market conditions. Also discussed in a previous article is how market orders essentially take liquidity from the marketplace, while limit orders add liquidity. Orderbook depth refers to the ability of the marketplace to absorb large market orders without moving price drastically in any given direction. This depth can also be thought of as liquidity - the ability to transact in large size without severely impacting price.
In slow moving markets, where transactions are occuring at regular intervals without large price movements, it is relatively easy to take a snapshot of the orderbook and calculate its depth. However, when price is moving up or down quickly, this becomes much more complex as market participants either change or remove limit orders from the market. If price is falling, market participants may remove their bids (resting buy orders) until price falls to a point where buyers are again willing to transact. Due to the nature of markets, liquidity is dynamic and orderbook depth changes based on price movement. This fact gives rise to liquidity risk in the market.
Liquidity risk is of extra importance to larger market participants, especially if leverage or adverse price movements causes them to transact at unfavorable levels. There are several ways to track and gauge liquidity risk: the bid-ask spread, market depth, and Value at Risk (VaR) over larger time periods. For institutional players, VaR is tracked both at a one day and a 10 day timeframe; the latter being used to account for liquidity concerns (as it may take several days to unwind a large position). There is also a liquidity adjusted Value at Risk metric under development (not yet widely used in an institutional setting). The bid-ask spread and market depth must be analyzed in time periods of stress in order to give a realistic expectation of liquidity.
Orderbook depth refers to the ability of the marketplace to absorb large market orders without moving price drastically