What is an Order Book?
With the ever-evolving landscape of technology, electronic trading is becoming more intricate and multi-dimensional. This allows traders to capitalize on buying or selling different digital assets with newfound efficiency through order-matching systems that are faster than ever before. This provides an opportunity to completely revamp their trading strategies, giving them a wholly unique experience in the process.
The order matching mechanism is the heart of any exchange, and performs one of the most important functions – maintaining the stability of the financial market through the continuous processing of incoming orders to buy or sell financial assets. The concept of a market order is familiar to every trader, regardless of experience, as it is one of the key concepts in the field of trading and reflects the process of making deals to buy or sell an asset at a certain price at a certain point in time, formed and displayed in a special section of each exchange called an order book.
This article will shed light on the question of what an order book is and how it helps determine the mood of traders in the market. In addition, you will learn how the order book works as an important part of the order-matching system. In the end, we will talk about the main components that make up any order book within the framework of trading.
Order Book: The Key Indicator of Market Sentiment
The price on exchanges is always formed as a result of the interaction of two parties – buyers and sellers. The dynamics of this relationship are reflected in the so-called order book. Essentially, it is a tool that visualizes a list of outstanding buy and sell orders for a particular asset in real time. The order book reflects the interests of buyers and sellers, dividing the market by the level of supply and demand. Although all order books serve the same purpose, they may look slightly different on different exchanges. Nevertheless, all order books are structured similarly, with similar functions and qualities.
While order books were originally associated with stock exchanges, they are now gaining popularity in cryptocurrency trading. There are two types of order books. A level 1 order book shows basic market data such as prices and best buy and sell prices. Level 2 order book shows detailed information such as market depth. Market depth (depth of supply and demand) is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. This number is usually displayed above the order book and is dynamically updated as orders are canceled or executed.
Market depth and overall market liquidity are closely intertwined. The order book’s amount of buy and sell orders at distinct price levels is the key determinant for such a relationship. Generally speaking, the greater the market depth – meaning more buyers and sellers present – the higher its liquidity will be. If many buy and sell orders are placed at deep price levels without having a strong effect on the asset’s price, this indicates a liquid market because the order book can absorb larger market orders.
Conversely, when market depth is weak, large buy or sell orders push an asset’s price down or up, “depleting” the order book and disrupting market makers’ positions. The depth of supply and demand tends to expand to account for this risk. By analyzing depth, you can determine the degree of risk to which market makers are exposed, depending on the depth and liquidity of the market, which suggests that markets with low liquidity are more challenging to exchange assets at stable prices.
Order Book as a Part of Matching Engine Software: How Does It Work And Why Is It Important?
The order book is a list of pending buy and sell orders for a particular asset and is a visual representation of the matching results.
Order books assist traders in making better trading decisions. If there is an imbalance between buy and sell orders, it can hint at which direction the price may move in the very short term. For example, if it is observed that the number of buy orders is significantly higher than sell orders, this could indicate an upward price movement due to buyer pressure and vice versa. Traders can also use the order book to find potential support and resistance levels. A large cluster of buy orders at a certain price could indicate a support level, while a multitude of sell orders at or near a certain price could be seen as a resistance zone.
Order matching is primarily the market makers’ and liquidity providers’ responsibility. Matching occurs when buy and sell orders submitted for the same stock or security are close in time and price. Buy and sell orders are considered compatible if the maximum price of a buy order exceeds or equals the minimum price of a sell order. Compatible buy and sell orders are then prioritized using computerized systems for matching.
Accuracy and speed of order matching are crucial in today’s exchanges. If the order matching system lags, buyers and sellers may trade at lower prices than the ideal trading prices. Thus, this can lead to losses for traders. Therefore, the order matching system should be efficient so that buyers and sellers benefit equally and maximize the volume of orders.
Basic Components of the Order Book
The order book, being the main reference point for traders and investors to analyze the market situation, is an element of a visual display of information about the depth of the market, showing the readiness of traders to conclude deals to buy or sell. The order book consists of a number of components that, when interpreted correctly, can provide invaluable insight into the state of the market. Let’s consider them in a little more detail.
This column reflects the price range in which each individual line is the price of buying or selling an asset based on limit orders currently in place. As orders are filled or canceled, the price structure of the order book may change, especially for highly liquid assets where dozens of transactions can take place every second.
This indicator represents the volume of the bought/sold financial instrument, expressed in integer and decimal numbers, which is currently in a limit order at a certain price. As a rule, after placing a limit order, it is not possible to change its volume. A trader can cancel a limit order and place a new one with a new indicator of the amount of the asset being bought or sold. This indicator can be expressed in the absolute value of the amount of the tradable asset or in stablecoins, such as USDT.
This column shows the total amount of all open limit orders for both buying and selling at a certain point in time and clearly shows at what price level the majority of buyers or sellers are concentrated. Based on this information, it can draw a conclusion about what price is the most attractive for market participants. This indicator can be expressed in the absolute value of the amount of the tradable asset or in stablecoins, such as USDT.
Although the order book is intended to provide transparency for market participants, there are some details that are not included. Among them is the so-called “dark liquidity”. These are hidden order pools maintained by large players who do not want their trading intentions to be known to others.
Without dark pools, exchanges would see a significant devaluation of prices. When information about a major transaction by a large institution is made public before the transaction takes place, it usually causes the price of a financial instrument to plummet. But if the transaction is disclosed after it takes place, the impact on the market can be greatly reduced. Therefore, the presence of dark pools reduces the usefulness of the order book to some extent since it is impossible to know whether the bids shown in the book represent the true supply and demand for the stock.
The order book is an indispensable universal tool that allows you to analyze the state of the market and make appropriate decisions regarding the purchase or sale of certain assets. Being the most important indicator of supply and demand in the market, the order book contains all the necessary information regarding how many buyers and sellers are willing to trade at any given time at a particular price level. With this, you can adjust your trading strategy accordingly to make wise decisions when it comes to asset trading.