Order Book Explained: How It Works and Its Importance

Everyone in the stock market, whether a novice or experienced, has to deal with the ever-changing market dynamics. It is essential to be able to execute trades timely by capturing the pulse of the market using various tools. An order book is one such tool that shows the buy and sell orders for an asset along with volumes at any particular time. If you are an intraday or short-term trader, then along with technical analysis, you must understand the Order Book to be able to make better trading decisions.

In this blog, we will give you an overview of the Order Book, its key features and how it works.

What is an Order Book?

An Order Book is an electronic record that shows the buy and sell orders placed by market participants related to a specific asset class, such as stocks, cryptocurrencies, or commodities. The order book contains two windows representing bid prices and ask prices. The bid price is the highest amount a buyer is willing to pay, and the ask price will reflect the lowest price which a seller is ready to accept. Moreover, the quantity associated with the orders is also shown. The trading system continuously updates the order book as per the changes done by the market participants.

Features of Order Book

The key features of the order book are mentioned below:

• The order book reflects the true intentions of buyers and sellers in the market.

• It also reflects the total buy and sell quantity, which helps the traders in determining the market sentiment.

• Different types of orders, such as market orders, limit orders, etc., can be placed from the order book.

• The best bid and best ask prices are also visible in the order book, which helps determine the bid-ask spread to gauge market liquidity.

• The order book provides transparency to the traders and creates a sense of confidence among them.

Components of Order Book

Various components constitute the order book, and having a better understanding of it helps the investor make informed decisions. The components of the order book are:

• Bid Prices – Bid prices refer to those prices at which buyers are willing to purchase the asset. The highest bid is generally shown at the top, which indicates the highest price offered by the buyer.

• Ask Prices – Ask prices refer to the prices at which the seller wants to sell the asset.

• Volume – Along with the bid and ask prices, the total quantity of assets at different price levels is shown at a particular point in time.

• Spread – The difference between the bid and ask price is known as the spread, which represents the asset’s liquidity.

• Pricing – The orders that have the highest bid and lowest ask price will be given priority over other orders. 

• Priority – If the orders have the same prices, then the orders placed earlier get priority over orders placed afterward.

• Liquidity – The total market depth lets us know the liquidity available in the market.

How Does Order Book Work?

There are various rules and regulations based on which the order book works, a few of which are mentioned below-

1.  Order Matching – The primary function of an order book is to match the buy and sell orders placed in the system based on the algorithms. The matching process involves pairing buying orders with the corresponding sell order; for example, a market sell order is matched with the best bid, whereas the market buy order is best matched with the sell order with the lowest ask price.

2.  Spread – The difference between the highest bid and lowest ask price is called spread, which reflects the liquidity and sentiment of the market. The smaller the difference between bid and ask price, the higher the liquidity and vice-versa.

3.  Priority– According to the Timing Priority Rule, the order with the highest bid or the lowest ask gets filled first. If the two orders have the same price, the one placed earlier gets the priority. This rule was implemented so that every market participant gets equal opportunity irrespective of the size of the trade.

Interpretation of Order Book

Order Book is considered a comprehensive catalog of bid and ask prices and the quantities of the security offered at each price level. It updates in real-time as the market prices of an asset fluctuate. It can be considered as a screen of war between the buyers and sellers.

Each entry of the bid price and ask price, along with the quantity, reflects the interest of buyers and sellers. The system continuously updates the order book based on the orders entered, modified and canceled by the investors or traders, which results in dynamic data displayed on the screen.

Dark Pool Orders

Dark pool orders are those orders that allow a specific entity, such as investment banks and hedge funds, to place a large order into the exchange without revealing it to the other market participants. It allows the entities to place orders anonymously without affecting the market prices.

For example, suppose an investment bank wants to sell INR 500 crore worth of securities. The bank doesn’t want other market participants to know about the trade because if the general public knows about the trade before the bank executes it, the general public will get in on the action and would cause the market price of the securities to decline significantly, causing the bank to suffer losses.

Conclusion

On a concluding note, the order book is the backbone of the Indian trading system. It allows an investor to get an idea about the available bid and ask prices in the system and the total quantity offered, which helps traders make informed decisions. The liquidity and the market trends can also be determined using the order book. The objective of the implementation of the order book is to provide transparency in the trading system. It doesn’t matter if you are new to trading or an experienced trader; understanding the order book is crucial.

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