What is an Order Book?

What is an Order Book?

The term order book refers to an electronic list of buy and sell orders for a specific security or financial instrument organized by price level. An order book lists the number of shares being bid on or offered at each price point, or market depth.

It also identifies the market participants behind the buy and sell orders, though some choose to remain anonymous. These lists help traders and also improve market transparency because they provide valuable trading information.

Components of an Order Book

The outline of an order book can vary between the recorded securities. However, it usually consists of several components, as listed below:

1. Buyer’s side and seller’s side

An order book is a market price recorder. Therefore, it includes a buyer’s side and a seller’s side – the two major participants in a market.

2. Bid and ask

Instead of using a buyer’s side and a seller’s side, some order books use the terms “bid” and “ask.” Buyers are the ones who “bid” for a certain number of shares at a specified price, and sellers “ask” for a specific price for their shares.

As a rule of thumb, the buyer’s side (bid) is on the left, and the seller’s side (ask) is on the right, colored green and red, respectively.

3. Prices

An order book records the value interest of both sides. The number in the buyer’s or seller’s columns represents the amount they are bidding or asking for and at what price.

4. Total

The total columns are the cumulative amounts of the specific security sold from different prices.

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5. Visual demonstration

Normally, an order book comes with a table of numbers consisting of prices and total amounts from two sides. To better represent the relationship between buyers and sellers, most of the order books come with a visual demonstration as well. It can be in the form of a line chart or others. In this way, the reader can quickly achieve an overall understanding of market demand and supply.

Pros and Cons of Order Books

Pros

  • It helps measure the market sentiment of a particular security
  • Gives investors an indicator of whether there is a bullish or bearish trend for that security

Cons

  • Order book info may not be relevant for long-term investors
  • Order book trends can change quickly

Pros Explained

  • Helps measure market sentiment of a particular security: The ability to view how many trades are placed at a specified price is an indication of the market’s overall sentiment for the underlying security.
  • Gives investors an indicator of whether there is a bullish trend or a bearish trend: Seeing orders placed for buyers and sellers at a range of different prices with their respective volumes can indicate whether a security may have an upward or downward movement in the near future.

Cons Explained

  • Order book info may not be relevant for long-term investors: Investors who use the order book to place a trade are often short-term day traders or investors looking to determine the opportune time to enter the market.
  • Order book trends can change quickly: The order book is updated in real time, making the data you have time-sensitive. If you are basing a trade on order-book data, keep in mind that the data may only be relevant for a short time.
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What is an order book used for?

The order book of an exchange is used to help traders make better decisions, by enabling them to measure market sentiment at any given time.

The information that can be found in order books might not be that relevant to buy and hold investors, as intraday movements have little impact on their overall strategy. But for short-term traders, the improved transparency of the financial markets can help them to identify key trends and the balance, or imbalance, of buyers and sellers.

Order books can give a clear indication as to whether the bulls or bears are in charge of a market. For example, if there is an abundance of sell orders compared to buy orders, it could be taken as an indication that the market is due to decline amid selling pressure.

Example of an Order Book

Order books continue to collate an increasing amount of information for traders for a fee. Nasdaq’s TotalView claims to provide more market information than any other book—displaying more than 20 times the liquidity of its legacy Level 2 market depth product.

While this extra information may not be very significant to the average investor, it may be useful to day traders and experienced market professionals who rely on the order book to make trading decisions.

Conclusion

An order book is a useful tool for traders. Learning how to read it can help traders tremendously in understanding the market they’re currently trading in or about to enter. Studying the order book in the long term enables traders to know whether or not the market of a security is healthy.

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The more information traders can learn about the market, the more informed decisions they can make about their orders.