An Introduction to Limit Order Books

An Introduction to Limit Order Books | machow.ski

#trading

What makes a market

• buyer & seller, make a trade

• The purpose of exchanges is to pool all of this activity in one place, and efficiently facilitate two very important things

  • Liquidity

  • Price Discovery

• Liquidity: The ease with which an asset, or security, can be converted into ready cash without affecting its market price.

  • PS5 shortage example

  • Manufacturet → Seller perspective

  • Liquidity is the ability of the market to absorb sales/purchases without the price moving drastically.

  • The higher liquidity the better!

• Price Discovery: The process by which the spot price of an asset is set.

  • walking around all the market and finding the price/value

  • seller set the proper price

  • order book helps to make price discovery

Order Book Struct

• One Order

  • side

  • quantity

  • limit price

  • submission time

Price/Time Priority

• 1st: price sort

• 2nd: same price, time sort

Executing Trades

• passive

  • limiti price

• aggressive: a limit order goes beyond the best price of the opposite side.

• bid/ask spread: a gap between the best bid and ask price

  • near touch: The top of the book which is the same side as the order

  • far touch: The top of the book which is the opposite side of the order

• aggressive order → trade more than 1 time

• Multiple Level Trade

  • cross more than 1 order

  • volume weight average price

• Trading Terminology

  • Basis Points, 1% = 100 bps

  • Hitting the Bid / Lifting the Ask, submitting an aggressive order against the opposite side

  • Volume, the amount of shares traded in a certain time period

• Trading Fee

  • Maker: Passive order

  • Tacker: Aggressive order

• Order Type

  • Limit

  • Market

  • Stop

• Time in Force

  • Good Till Cancel(Default)

  • Day

  • IOC: Immediate or Cancel, if the order is aggressive, will be tither fully or partially filled; Remaining quantity left will be canceled.

  • FOK, Fill or Kill, If the order cant be fully filled in the current book. will be cancled

• Post Only Order: No aggressive

• OrderBook Market Data

  • L1: only the top of the book

  • L2: can see the depth, price level

  • L3: all of the individual orders in them as well.

• Order Visibility

  • Hidden Order

  • Iceberg Order: An iceberg order allows the participant to achieve this functionality without having the manually place and replace the smaller orders.