Introduction: What is an order book?
An order book is an electronic list that details the buy and sell orders of a specific security or any financial instruments. The list is organized by price level. Order book books are used by almost every exchange for various assets like stocks, bonds, currencies, and even cryptocurrencies. These lists help improve market transparency by providing information on price, availability, depth of trade, etc.
Understanding Order Book
Orderbook can be both manual and electronic. However, most order books are electronic in today’s digital age. In terms of information, most of the order book contains similar information. However, their design, placement, content, and structure may differ based on the platforms.
Components of an order book
There are generally following parts to an order book –
Buyer’s and Seller’s sides
An order book is a price recorder and includes the Buyer’s and Seller’s side – the two participants of the market.
Bid and ask
Some older books use the terms “bid” and “ask” instead of Buyer’s and Seller’s side. Buyers are for “bid”, and sellers are for “ask”. Where buyers bid for a certain number of shares at a specific price and sellers ask for a specific price for their shares. As a general practice, the bid is on the left and the ask is on the right and are coloured green and red respectively.
Order book records the interest of both buyers and sellers. Column in both Buyer and seller sides represents the amount the buyers and sellers are bidding or asking for.
The total columns are the cumulative amounts of the specific security sold from different prices.
When you look at the order book, you will see it is dynamic, with the numbers changing in real-time. When the numbers change, the buy and sell orders are fulfilled or canceled. The process is through a process called matchmaking.
Matchmaking tends to match buy and sell orders. When a buy order for Rs 2305 for ten stocks of Reliance Industries Ltd, the match is made with a sell order at the same price. If the sell order was only for two stocks instead of ten, the buy order is partially fulfilled, and the remaining is outstanding as a partial open order for which another sell order is scouted.
All this buying and selling takes place quickly in a digital exchange, with orders being executed in seconds.
How to read order book
The top of the book is the highest bid, and lowest ask price. This points to the pre-dominant market where the price needs to be executed.
For Example, a significant imbalance in the buy-side vs sell-side may indicate an upward or downward movement in the stock.
Also, a cluster of large buy orders at a specific price suggest a support level where an abundance of sell orders at or close to one price suggests an area of resistance.
Advantages of the Order book
An order book, as mentioned previously, shows the price of a security in real-time and participants’ interest in terms of buying and selling. This allows participants to make informed decisions. It helps investors/traders understand the market trend and dynamics over time.
Uses of the order book
With order book-matchmaking characteristics, orders are matched automatically. The most common example here is fulfilling an order based on demand and supply.
Another example is where a trader or investor applies any limit strategy. In such scenarios, traders can set a specific level at which they want to buy or sell a security. Whenever the current price of the asset moves to the set price, the orders placed are completed automatically.
Interpreting spread, market depth and liquidity
The bid-ask spread or spread is the difference between the highest price for buying and the lowest selling price. The number is generally seen above the order book and updated dynamically as orders are canceled or filled. The spread is used as an indicator for the demand and supply of the asset. Additionally, bid spread also relates to the market’s liquidity that evolves from market makers to price takers. Thus, the tighter the spread, the more liquid the market is. It isn’t easy to exchange assets at stable prices in a market with low liquidity.
An order book is a helpful tool for investors and traders as it helps you understand where the opportunity lies. Order Book helps you evaluate the spread in the market and understand the market depth. It also helps you evaluate the resistance and support level and often helps predict the stock’s movement based on the flow of orders. Studying order books is generally one of the first steps for traders looking to make money with small opportunities in the market in a short duration.