What is an order book?
An order book is a ledger that contains all pending orders for a particular cryptocurrency. These orders are divided into two main categories: buy orders, which show the prices at which traders are willing to purchase a cryptocurrency, and sell orders, representing the prices at which sellers are ready to sell a cryptocurrency.
How does an order book work?
The orderbook operates on a simple principle: matching buy orders with sell orders. Each side of the order book is organised by price and time priority. This means:
- Limit buy orders are listed from highest to lowest price, showing the demand. The topmost buy order represents the highest price a buyer is willing to pay and is known as the “bid.”
- Limit sell orders are arranged from lowest to highest price, showing the supply. The lowest sell order is the “ask” and represents the lowest price a seller is willing to accept.
The difference between the highest bid and the lowest ask is called the spread. A narrow spread usually indicates a healthy, liquid market, whereas a wide spread signals lower liquidity.
Market orders vs. limit orders
There are two primary types of orders:
- Market Orders: These orders are executed immediately at the current market price. If you place a market buy order, it will match the lowest available sell order on the orderbook. Similarly, a market sell order will match the highest buy order. Market orders are used when the priority is speed over price control.
- Limit Orders: With limit orders, you specify the price at which you wish to buy or sell a particular cryptocurrency. These orders are added to the orderbook and executed only when the market reaches your specified price. This gives you better control over the price but does not guarantee execution, as the market might not reach your desired price.
Order book example
In this example, several buy limit orders have been placed on the order book for Ethereum Classic (ETC). Here’s a snapshot of the current buy-side:
- The top order offers to buy 186.1 ETC at a maximum price of $40.90.
- Below that, another order is looking to buy 321.51 ETC at a maximum price of $40.89.
- The next order in line wants to buy 0.059 ETC, but only at a price of $39.94.
What happens next if someone wants to sell their ETC?
If a seller decides to place a market order to sell ETC, this order will immediately match with the available buy orders starting from the highest bid. For instance, if someone wants to sell 507.67 ETC (which equals the total of the ETC amounts in the first three orders), they would:
- Sell 186.1 ETC to the first buyer at $40.90.
- Sell 321.51 ETC to the next buyer at $40.89.
- Sell 0.059 ETC to the buyer at $39.94.
- Sell the remaining 0.001 ETC to the buyer at $39.74.
After fulfilling these orders, if the seller still wanted to sell more ETC, the next highest available buy order is at $38.71. This highlights how market orders are executed against the standing limit orders on the buy side, and how quickly the available price can change as orders are filled.
The peer-to-peer nature of exchange trading
A common misconception is that when you buy or sell an asset on a cryptocurrency exchange, you are transacting directly with the exchange itself. However, this is not the case. Exchanges act as a facilitator or intermediary for trades between users.
When you place a buy order for a cryptocurrency, you are expressing your willingness to purchase that cryptocurrency at a specific price. Conversely, when you set a sell order, you are indicating your readiness to sell a cryptocurrency at your chosen price. The order book collects these intentions from all users and organises them by price level.
You are essentially buying from or selling to other users on the platform, not the exchange itself. The exchange’s role is to match buyers with sellers based on their orders. When a buy order and a sell order match in terms of price, the exchange executes the trade. This system ensures that the trading process is transparent, efficient, and, most importantly, fair, as it is driven by the supply and demand dynamics created by users’ orders.
What is liquidity and why does it matter?
Liquidity refers to how easily a cryptocurrency can be bought or sold in the market without affecting the asset’s price. High liquidity means that there are many orders in the orderbook, making it easier to execute a trade at your desired price. Conversely, low liquidity implies fewer orders, which can result in significant price slippage when a trade is executed. Price slippage occurs when the actual execution price differs from the expected price due to changes in supply and demand.
The impact of thin liquidity
When the orderbook is not dense enough with orders, any sizable trade can substantially move the market price, leading to less favourable rates. This is especially common in markets for less popular cryptocurrencies or during times of low trading volume.
Using market orders: When you place a market order, it will automatically seek the best available price in the order book. If the volume at that price is insufficient to complete your order, and the next available price is within 10% of the original, the order will continue to fill at this new price. This ensures quicker execution of your trades but requires attention to the potential for price changes, especially in less liquid markets.
How can you use this information?
Understanding the dynamics of orderbooks and liquidity can significantly enhance your trading strategy. Here are a few tips:
- Monitor the orderbook: Before placing a trade, examine the depth of the orderbook to gauge the market’s liquidity. Look for a narrow spread and a balanced distribution of buy and sell orders.
- Utilise limit orders: To exercise greater control over your trades, use limit orders to specify the price at which you are willing to buy or sell. This can help you manage risk, particularly in less liquid markets or during times when price fluctuations are significant. By setting a limit order, you ensure that your trade only executes at a price that meets your criteria, which can help in managing costs and optimising entry and exit points.
- Consider trading times: Trading volumes can vary throughout the day. Trading during peak hours can often lead to better liquidity and tighter spreads.
- Adjust your strategy: If you’re trading large volumes in a low-liquidity market, consider breaking your trade into smaller orders to minimise impact and avoid significant price slippage.
