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I am implementing a pretty simple market making strategy. I want to see if the demand is higher than the supply in the short term so that I will be able to buy and sell decently fast. My goal is to be able to buy and sell within the same minute, if certain market conditions are met.

I've thought about checking the order book and looking at the first 5-10 prices on the buy and on the sell side and then compare them. If there is more volume on the buy side than volume on the selling side, then I can assume that there is more demand than supply currently on the market.

Then I will check the time and sales and see if there were more transactions to buy than transactions to sell in the past 30-40 transactions.

Is it correct to think about short term supply and demand this way ? I'm using a market making strategy in a mean-reverting highly liquid market.

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Well, the first approach you mentioned is called orderbook imbalance while the second is trade imbalance. It is hard to say whether those are "correct" or "incorrect" approaches because it all depends. However, those two approaches can be used as price discovery.

In the first approach, I would ask why 5-10 levels? How far is the price at depth 10? If volatility is low and depth N price is unlikely, than it is not a good measure of short term measure of supply/demand. Depth parameters should reflect what short term means for you.

Same can be said about the number of transactions. Overall, orderbook/trade imbalance is a good starting point.

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  • $\begingroup$ I choose 5-10 levels because the price is not that far ahead in those levels and it's so volatile that it changes very rapidly (once every 2 seconds at least). This is why I thought it's a good starting point. I've now also added, besides time and sales and order book checking, short and long term EMA. I first check EMAs, then time and sales, then order book and if everything seems to be right, I buy. $\endgroup$
    – David
    Commented Oct 20, 2023 at 7:39

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