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How to read the order book

In our previous example, we explained the basics of the order book. We also briefly touched upon the key aspects that make up the order book. In this article, we will look further into what an order book and how to read and interpret the information.

To quickly touch upon the market depth once again, it is a measure of the volume of limit orders in real time. The market depth represents the trading platform or the exchange's activity.

Generally speaking, the more activity there is in the market depth, the more interest there is for the security in question. The order book, as we noted earlier is not limited to only stocks and futures.

In fact, now a days, even forex brokers allow the use of order books. But the main difference here is that the orders you see in the forex markets pertain to only the liquidity pool for the forex broker you are trading with.

Therefore, in other words, the order book in forex is not an accurate representation of the full scope of the foreign exchange markets. While, for example you might see a pending order on the bid side for 50,000 contracts for a EURUSD currency pair, in reality the order for that currency at the said price level could be even higher.

Therefore, in the retail forex world, traders need to bear this in mind. True order book data is available only on exchanges such as futures or stocks.

Reading the order book

The Order book basically shows the number of limit orders that are active at each of the specified price levels. In many cases, the order book shows the pending orders which are close to the current market price.

Therefore, generally speaking, you would see up to five pending orders each on the bid side and ask side.

An important thing to note about order book is that they only show the pending orders. As you might know, a pending order can be cancelled at any time. Therefore, it is important that traders understand this thoroughly. Just because you see a huge buy or sell order in the order book does not guarantee that it will be executed.

Traders can just as easily cancel the orders.

Another factor to bear in mind that market orders are not displayed in the order book. This is for the fact that the trades are executed at market and are not placed as pending limit orders. Many traders tend to make the mistake of looking at an order book and instantly thinking that the market is bullish or bearish.

But this is not the case, because as we mentioned earlier, the order book is merely a representation of the limit orders and do not reflect the actual orders that have been executed. It is due to this misconception that traders often fall into the mistake.

Once such example is the case of a British trader, Navinder Sarao who managed to fool the traders by spoofing orders using the order book. You can however imagine the power of the order book due to the psychology involved.

Traders automatically start to think that they can gauge the market sentiment. This can work, but only some of the times.

What information can you gather from the order book then?

While the order book only shows you the trader’s interest to buy or sell an instrument at the said level, it does not show the actual executed trades. To get this information, you will either have to look at the more micro, time and sales report or the daily trading volume information.

But having said that, the market order book can give you some interesting insights. Firstly, by looking at the quantity of orders at the price levels, you can easily deduce the trader sentiment. For example, if you see that there is an unusually large interest on the bid side, then it would mean that the market sentiment is likely bullish.

But of course, you will have to validate this further on by either reading up on the fundamentals or doing your own analysis or study of the instrument in question. But having said that, the order book is simply one of the many tools that you will have to use.

This type of analysis falls into the order flow type of analysis. While complex at first, it can provide interesting insights, especially in the very short term. This can be beneficial for intraday traders. In the next article, we will cover what the order flow is and go more deeper into volume analysis.

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