Depth of Market as used in finance. The WoM indicator can be used to quickly show the balance of back and lay offers on either side of the spread. If the weight is in favour of the lay side then it suggests the price has bottomed out (for how long, we don't know) and that the market is willing to lay in the hope that the price goes out. Conversely, if the weight is in favour of the back side then the price is expected to fall.
An algorithm for calculating WoM is given by
WoM = Money on Best Three Best Lay Prices / (Money on Best Three Lay Prices + Money on Best Three Back Prices)
and yields a value from 0 to 1.
The indicator is read thus
WoM = 0 to 0.33, more lay money entering the market so price is expected to rise
WoM = 0.33 to 0.66, money to back/lay are roughly equal so price is likely to remain stable
WoM = 0.66 to 1.0, more back money entering the market so the price is expected to fall
= (£33 + £25 + £126) / ((£33 + £25 + £126) + (£15 + £44 + £104))
= £184 / £347
= 0.53 (price is expected to remain stable)
In the financial world much has been said about high frequency trading and market manipulation. Complaints are made about computers creating false signals by placing large orders on one side of the current bid/ask spread for an asset, thus creating a false signal of intent. The order creates the illusion of demand and some traders may jump into the market because of this. As soon as the price moves in the desired direction the large orders are removed and a smaller stealth position has profited from the price movement.
On Betfair you will sometimes see an order (many times bigger than current orders) placed a tick away from the current spread, which skews the WoM. The order is removed a few seconds later with none of the order having been traded. I think most experienced traders are aware of this occurrence and take this in their stride. However, naive traders using bots might get trapped into a manipulative trade if their algorithms solely use WoM as a trigger.
There is also the chance of bots working through two different accounts backing and laying at the same price to create the illusion of liquidity. Of course, such activity is going to attract a commission so those who do this self-matching will have a low commission rate and will have some idea of where the price is going to move to. No doubt they will have orders elsewhere on the price ladder to take advantage of this.
Does WoM Really Work?
Yes and no. You are as likely to find as many cases of WoM giving a false signal as a positive signal, in certain situations. It all depends on how and when you use it. All trading software will have the WoM signal and my self-coded trading software has it too but it is only a small part of my view of the market.
Our "scalping" friends will tell us that they can simply look at WoM and get a feeling when the market is going to move. I would challenge a room full of scalpers to press a key the moment such an event was going to happen. The result would be 50% right or wrong. You can never pin a scalper down to a figure, just a feeling.
Of course, you will see the scalpers piling in on one side of the spread when it looks as though a move is about to begin. But this happens so fast, close to the beginning of a horse race, that looking at WoM is more of a distraction than anything else. I don't need to look at a WoM indicator to see money entering the market.
Everyone has their own reason for entering a market and their own precise moment to do so. The market is too chaotic for something as simple as WoM on its own to use but in combination with other metrics it can be of help to the trader. For myself, WoM confirms what I have gleaned from other metrics that I calculate and from charts that I observe. I don't take the WoM alone as a signal but merely use WoM as a way of supporting the hypothesis of my current trade.
Weight of Flow - An Alternative Approach
I prefer to look at the weight of flow of money. In this you view the side on which money is being matched. You can see this by using 3rd party software or by coding your own software. If the software is set-up to signal how much money is being traded on either side of the spread then you will see if people are favouring the back or the lay side. This is regardless of how much money is sitting on either side of the spread, which is sometimes erroneous and sometimes deliberately so.
Programming for Betfair, a guide to creating sports trading applications includes a section on calculating WoM for Betfair data as it is received from the server. The book demonstrates to the reader how they can build an application to receive data from Betfair, calculate their own trading indicators and trade upon indicator signals automoatically through the creation of a bot.
Betfair Trading Techniques extends on weight of money/flow by showing how volume analysis can open up new views on market activity.