What is an order book in trading?

01 Orderbook Image

When it comes to trading, for many traders their job almost ends after they have placed an order. But behind the scenes, there is a lot more going on than what meets the eye. Among the many processes, order book is one of the critical operational aspects for an electronic trading business.

Within itself, understanding order book can be of some value for traders. Most importantly, there is a field in analysis known as order book analysis. This is where traders look at the order to identify trading opportunities.

While order book trading is similar in terms of the way one would apply technical analysis, order book trading is a different ball game altogether. The first step with this is of course in understanding what is an order book and how it works.

What is an order book?

An order book is a type of a book that can be either manual or electronic. It is used to log all the bids and offers for a security by its price. An order book is usually electronic these days. Examples of where order books are used include trading exchanges and even with some forex brokers.

Based on the entries in the order book, a matching engine automatically matches the buy and sell or the bid and offer prices. An important thing to note is that the entries in the order book are merely an expression of interest. Just because there is an entry for a buy order of 100 million lots at a certain price doesn’t mean that the order will be executed.

This happens because with order books, the entries are logged. But these orders can be cancelled as well. Thus, when using an order book, one will not know if the orders will indeed be executed or not, until they are.

An order book is updated in real time as and when orders are placed.

02 Orderbook

Example of an order book (Source: Oanda)

Another term for the order book is called Depth of Market or DOM

The anatomy of an order book

An order is typically made up of two sides. The buyers and the sellers. These columns contain a list of the pending buy and sell orders. An order book entry consists of the price and the number of bids and offers.

Within the order book, there are two levels of information that one can obtain. Generally, the level 1 or L1 is widely used. But one can also get access to the level 2 or L2 information at an extra cost.

The level 1 data includes just the bid and ask prices for the security. It also comprises of the last price and the number of contracts that occurred at the time of the last transaction.

The level 2 data on the other hand gives more detailed information. The data includes, the top 10 highest bids and the top 10 lowest ask prices along with the number of contracts at these levels.

Order books find their importance mostly when the assets in question are traded at an exchange or at a centralized venue. It doesn’t work the same way when dealing with over the counter assets or derivatives products.

Trading based off order books

Over the past few years, order book trading has stood its own grounds. Over the course of the years, traders have now developed patterns that can signal potential trading opportunities. The question on how reliable an order book is compared to basic technical analysis is of course debatable.

Still, many practitioners of order book analysis often swear by its uniqueness. It would be a folly to think that switching to order book analysis will help you become a better trader. At best, order book based analysis can give you only some insight.

There are a number of third party tools that are available when it comes to order book in forex. However, one of the biggest flaws is that because order books are unique to a trading venue, one cannot fully get the bigger picture.

On the contrary, using an order book for trading exchange traded funds or stocks gives a much accurate picture as such assets are traded at an exchange and not over the counter.

One of the most common ways of using the order book is use its information to identify potential support and resistance or demand and supply levels. This can be one way to bring objectivity to the process of technical analysis compared to using the traditional methods of technical analysis itself.

Read 1028 times Last modified on Friday, 07 February 2020 07:40






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