The Limit Order Book

The limit order book is the list of orders (prices at which you can transact) for a given security.

• Depending on the security, these orders may be on one exchange, or aggregated across many exchanges.
• This presentation will give a basic description of the order book, and how your transactions will be handled by (and how they will affect) the book.
• You will transact in an order book if you trade stock, futures, options, and/or other securities. However, in this presentation we'll use stock examples.

Order Book Description

In the next slide, the plot on the right shows the full order book -- sell orders from \$11.38 to about \$12.50, and buy orders from \$11.36 down to about \$10.20.

• We generally only show the book 5 or 10 levels deep, as in the graphic on the left, which shows the book 5 levels deep.

Example:

Reading the first 2 levels of the book:

• There are 400 shares being offered for sale at 11.38, and 1600 shares offered at 11.39. This means, if we wish, we can buy shares at these prices.
• Similarly there are 2700 shares being being bid for at 11.36, and 1100 shares being bid for at 11.35. This means, if we wish, we can sell shares at these prices.

Inside Quotes

The inside quotes, which are also known as the Best Bid and Offer or BBO, are the highest bid, and lowest ask, in the order book.

• They are the prices at which the next market buy (with the best offer) or market sell (with the best bid) will transact.
• In the above book the inside quotes are 11.36/11.38.

The Bid-Ask Spread

In this case the bid/ask spread is \$11.36 - \$11.38 = \$0.02, or $$\ \frac{\$0.02}{\$11.38} = 0.1757\%$$

• The bid/ask percentage spread measures the cost to transact in that security---the larger the spread, the larger the transaction costs.

The Order Book and Liquidity

The smaller the bid/ask spread, and the more limit orders in the book, the greater the security's liquidity.

• Liquidity is a measure of your ability to cheaply transact (buy or sell) a security without moving the inside quotes by much.
• Sufficient liquidity is an integral component of a well-functioning market.

The Market Maker

A market maker's job is to maintain, at all times, bids and offers in the order book. This provides liquidity to the market.

• The market maker attempts to earn the bid/ask spread---repeatedly buying at the bid and selling at the ask.
• The order book is comprised of the market maker's limit orders, as well as limit orders entered by other investors and traders. However, the market maker must maintain orders in the book, and other market participants do not have this requirement.

Entering a Market Order

If you want to buy or sell a stock, one type of order you can enter is a market order. This will buy or sell the stock at the best available price in the market at the time the order arrives. With a market order, you are guaranteed that you will buy or sell; however, you are not sure of the price at which you will trade.

• A market buy will buy at the lowest ask price. If it buys all available shares at the lowest ask, the next ask above will become the new lowest ask, and that is where additional shares will be bought.
• A market sell will sell at the highest bid price. Similarly, if it sells all available shares at the highest bid, the next bid below will become the new highest bid, and that is where additional shares will be sold.

Use the app in the next slide to enter market orders and see the effect on the limit order book. On the left is the original book, and the right shows the book after the order is executed.

Entering a Limit Order

You can also buy or sell stock with a limit order. In this type of order, you specify the highest/lowest price at which you will buy/sell. With a limit order, you are guaranteed the price at which you will buy or sell (if the trade is executed); however, you are not guaranteed that you will actually trade.

• Say you enter a limit order to buy shares at \$50.03. Your order will sit in the limit order book until a sell order executes against your trade at \$50.03.
• Similarly, a limit sell will sit in the book until a buy order executes against your sell.

What if I enter a limit order to buy at \$50.03 and the present ask is \$50.01? Your broker will likely warn you, but if you enter the order it will immediately trigger, turn into a market order, and execute at \$50.01. A limit buy simply specifies the highest price at which you will trade---you will always get the best available price when transacting.

Use the app in the next slide to enter limit orders and see the effect on the limit order book. On the left is the original book, and the right shows the book after the order is executed.

Orders as Options

These order types are in fact option trades, and they can be valued accordingly.

• Placing a limit order sells an option because it allows someone to buy/sell the stock at a set price (although not for a set time).
• Placing a market order executes the option.