Depth Factor

Overview of Depth Factor.

The Depth Factor is a predefined numerical value that normalizes the influence of open interest imbalances between long and short positions when calculating the Premium and, subsequently, the Mark Price. In mathematical terms, it appears in the denominator of the formula used to compute the Premium:

$$Premium = Index\ Price \ *\ (long\ OI - short\ OI)\ / \ depth\ factor /\ 100$$

The Depth Factor essentially acts as a damping factor, preventing the Premium from becoming too volatile due to imbalances in open interest. Doing so ensures that the Mark Price remains a reliable and stable indicator, providing traders with a more predictable trading environment.

For traders, the Depth Factor offers an added layer of security against market manipulation and price swings that open interest imbalances might otherwise amplify. For example, in a situation with a significant difference between long and short open interest, a high-depth factor will reduce the impact of this difference on the Mark Price. This helps avoid undue price influence from outsized positions and creates a fairer market for all participants.

Example

Suppose the BTC index Price is $30,000, the Long Open Interest (Long OI) is 10,000 contracts, and the Short Open Interest (Short OI) is 9,500 contracts. Let's assume the Depth Factor is set at 1,500.

Firstly, we'll calculate the Premium using the given formula:

$$Premium = 30,000*(10,000-9,500)/1,500/100 \\Premium = 100$$

Now, we add this Premium to the Index Price to get the Mark Price:

$$Mark\ Price = Index \ Price + Premium\\ Mark\ Price = \$30,100$$

As a trader, what does this mean for you?

1. If you have a long position, this slightly higher Mark Price could benefit you, particularly if you're nearing the liquidation price. It gives you a bit more room before facing potential liquidation.

2. If you're holding a short position, this elevated Mark Price might bring you closer to your liquidation point, thus increasing your risk.

3. If you're planning to enter the market, this information is vital as it impacts the cost of opening a position and its liquidation risks.

In summary, the Depth Factor has moderated the impact of the imbalance between Long OI and Short OI, helping to keep the Mark Price stable and more resistant to manipulation. This contributes to a fairer trading environment and enables you to make more informed decisions as a trader.