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Order Book Basics

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wtl OrderBook

Order Book reading should be basic for a professional trader in order to understand how market works. It is the first source besides the so called Tape (Time & Sales) and is the direct source of second-level-market generated information - the most objective information that is derived from real positions taken in the markets by real people with real money. 

The Order Book visualizes  the "double auction" mechanism that allows buyers and sellers submit bids and asks simultaneously. Most financial markets use double auction mechanism. 

It is not my intention to reinvent the wheel! There are hundreds of videos and presentations about Order Book, its understanding and usage in the web.

My intention is to point you to some interesting aspects of an order book like

  • importance of Volume, Price and Time (read James Dalton)
  • Support and Resistance by Absorption
  • High Volume Areas (Volume Spikes) 

It is my duty as professional trader to see and understand where areas of interest are and whether and why I should pull the trigger to participate in the market. Therefore, understanding auctions and seeing them live is paramount for my job. 

Limit Order Book Terms

Limit Order

A limit order sits in the order book until it is:

  • either executed against a matching market order or it is canceled
  • A limit order may be executed very quickly if it corresponds to a price near the bid and the ask 
  • A limit order may take a long time if the market price moves away from the requested price
    • the requested price is too far from the bid/ask.
    • can be canceled at any time

  • Typically, a limit order waits for a match
    • transaction cost is known
    • execution time is uncertain

Market Orders

A market order is an order to buy/sell a certain quantity of the asset at the best available price in the book.

  • Agents can put a market order that, for a buy (resp. sell) order,
    • I the first share(s) will be traded at the ask (resp. bid) price
    • I the remaining one(s) will be traded some ticks upper (resp. lower) in order to fill the order size.

  • The ask (resp. bid) price is then modified accordingly.
  • When either the bid or ask queue is depleted by market orders or cancelations the price is updated up or down to the next level of the order book.
  • Typically a market order consumes the cheapest limit orders immediate execution (if the book is filled enough)
  • price per share instead uncertain (depends upon the order size)

Cancellations

  • Agents can put a cancellation of x orders in a given queue reduces the queue size by x 
  • When either the bid or ask queue is depleted by market orders and cancelations, the price moves up or down to the next level of the order book.

Limit Order Book Dynamics Summary

  • Actual trades come in two forms
  • Agents can put a limit order and wait that this order matches another one
    • transaction cost is known
    • execution time is uncertain

  • Agents can put a market order that consumes the cheapest limit orders in the book
    • immediate execution (if the book is filled enough)
    • price per share instead depends on the order size
    • For a buy (resp. sell) order, the first share will be traded at the ask (resp. bid) price while the last one will be traded some ticks upper (resp. lower) in order to fill the order size. The ask (resp. bid) price is then modified accordingly.

  • Agents can put a cancellation of x orders in a given queue reduces the queue size by x

  • When either the bid or ask queue is depleted by market orders and cancelations, the price moves up or down to the next level of the order book

 

I would like to warmly recommend the courses on the introduction to the order book of Prof. Richard Holowczak (Baruch College NY). Because they are so good and understandable I want to link the courses on my site.

 Let's start with the first of this series the "Limit Order Book"

After this clear and practical first lesson my recommendation is to have a look at the next video which explains "Limit Orders and Market Orders"

In further blog articles I will describe how to combine this necessary basic knowledge with trading related decisions. 


If you have any further suggestions, please write it in the comment.

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