What it means
Most modern exchanges operate as electronic order books. Each investor who places a limit order (an instruction to trade at a stated price or better) joins the queue at that price, and the exchange matches buyers and sellers automatically.
The highest bid and the lowest ask are called the best bid and best ask, and the gap between them is the spread. A narrow spread usually signals a liquid market, where trades can be made cheaply.
Orders at the same price are generally filled in the order they arrived, which is called price-time priority. This rewards participants who commit early to a price.
The book also reveals depth, which means how many shares are available at each level. A deep book can absorb a large order without much price movement, whereas a thin book makes prices jump.
Traders use the book to judge where support and resistance may lie, and to estimate the cost of executing a large trade. Because orders can be cancelled in an instant, however, the visible book is not a firm promise of liquidity.
Large orders are often split into smaller pieces or sent to hidden or dark venues to avoid revealing intentions. Understanding the book helps finance professionals see why quoted prices differ from the price actually achieved.
In practice
Real-world examples.
Example
A retail investor sees the best bid at $24.98 and the best ask at $25.00 for a share. She places a limit buy at $24.99, which narrows the spread and puts her at the front of the bid queue. Her order fills when a seller accepts that price. The spread of $0.02 means a buyer who crosses to the ask pays a little more than the midpoint.
Example
A pension fund needs to buy 500,000 shares of a mid-sized company. The trader sees that the book holds only 40,000 shares within 1% of the price, so he splits the order over several days. This limits the market impact of the purchase. The trader also checks the book each morning to see whether liquidity has improved.
Example
A market analyst studies the order books of two exchanges to compare liquidity. She finds that one has a spread of $0.01 and deep volumes, and the other a spread of $0.05. She advises the firm to route more trades to the first.
Formula
Calculation
Average execution price = Total cost of fills / Total shares bought
Suppose the ask side of a book shows 300 shares at $50.10, 500 shares at $50.20 and 800 shares at $50.30. A market order to buy 700 shares takes 300 at $50.10 and 400 at $50.20. Total cost = (300 x 50.10) + (400 x 50.20) = 15,030 + 20,080 = $35,110, so the average price is 35,110 / 700 = about $50.157. That is roughly $0.057 per share worse than the best ask, or about $40 in total for the order. The extra cost against the best ask is called slippage. Splitting the order or using a limit order would have reduced it, though at the risk of only a partial fill.Case study
Seen in the real world.
Marlowe Capital is an illustrative, fictional asset manager that needs to sell 100,000 shares in a small company. The book shows only 5,000 shares at the best bid of $10.00 and thinning bids below. A single market order would push the price down by about 4%, a cost of around $40,000.
The trader instead sells in small slices through the day and uses limit orders at $9.98 and above. The average price achieved is $9.97, a shortfall of only 100,000 x 0.03 = $3,000 against the starting bid of $10.00, compared with the estimated $40,000 for a single market order. The numbers are invented, but they show why order book depth matters.
Marlowe's head of trading now reviews the book depth before every large order and sets a maximum share of daily volume for each trade. The rule reduced average execution costs, and it gave the portfolio managers a simple way to compare traders.
Watch out
Common mistakes.
- Assuming the visible book is the full picture. Hidden orders and fast cancellations mean actual liquidity can differ.
- Using the last traded price to estimate execution cost. The cost depends on the depth of the book at the time. The last price may refer to a small trade that no longer reflects what is available.
- Thinking market orders get the best price. They take whatever is available and can move through several levels.
Questions
People also ask.
What are bids and asks?
Bids are orders to buy and asks are orders to sell, and the book lists both in price order.
What is price-time priority?
It is the rule that better prices are filled first and, at the same price, earlier orders are filled first.
Why does depth matter?
Depth shows how large an order the market can absorb before the price moves. Large investors study depth before deciding how quickly to trade.
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