What is an order book?
An order book is a constantly updated list of orders to buy and sell a specific financial instrument, such as stocks, bonds, or cryptocurrencies, in real time. These orders are organized by price level and time of entry, allowing traders to immediately see supply and demand for a particular asset.
In essence, an order book can be compared to an auction. Imagine an auction house where buyers bid on a valuable painting. Some are willing to pay a high price, while others are only willing to buy at a lower price. On the other hand, sellers have their own minimum price at which they are willing to sell a painting. This is the dynamic that the bid book shows, but instead of one auction lot, there are financial instruments, and instead of a physical location, everything is in a digital format.
How the order book is set up
- Bid and Ask Prices. The order book is divided into two main sections: the bid side and the ask side. The bid side displays the prices at which buyers are willing to purchase the asset (bid prices), while the ask side shows the prices at which sellers are willing to sell (ask prices).
- Price Levels. Each price level in the order book represents a specific price at which orders are placed. The levels are arranged in ascending order on the bid side and descending order on the ask side. The best bid price (highest) and the best ask price (lowest) are usually highlighted.
- Quantity. Alongside each price level, the order book displays the quantity or volume of the asset available for buying or selling at that price. It represents the total number of units traders are willing to buy or sell at a given price.
- Time Priority. Orders in the order book are generally arranged based on their time of submission. The earlier an order is placed, the higher its priority in case of price matching. This ensures fairness and allows for a "first come, first served" approach.
- Market Depth. Market depth refers to the cumulative quantity of buy and sell orders at each price level in the order book. It provides an indication of the liquidity available in the market and helps traders gauge the potential impact of their orders on the market.
- Market and Limit Orders. Order books accommodate two main types of orders: market orders and limit orders. A market order is an order to buy or sell an asset at the best available price in the order book, while a limit order specifies a particular price at which the trader is willing to buy or sell.
- Order Matching. When a new order is placed, it is compared with existing orders in the opposite direction (buy order with sell orders and vice versa). If the price and quantity match, a trade occurs, and the order book is updated accordingly. If a match is not found immediately, the order may remain in the book until a suitable match is available or until it is canceled.
Why is an order book important?
The order book is not just a list of buy and sell orders. It provides invaluable insight into market depth and liquidity, which can significantly influence trading strategies.
For example, a deep order book, with a large number of buy and sell orders at each price level, indicates high market liquidity. Such depth means that traders can execute large orders without significantly affecting the market price.
Conversely, a shallow order book can indicate low liquidity, which can lead to price slippage when large orders are executed. This information can help traders adjust their strategies accordingly.