Limit Order Books
Exchanges
Most electronic Exchanges use LOBs to match orders placed by buyers and sellers. LOBs have entered the mainstream in recent years with the popularisation of Cryptocurrency Exchanges. Understanding how a LOB works is essential for understanding the market-data published by these Exchanges.
An Exchange is a place where traders come together to exchange goods or services. Sellers offer their goods or services to buyers that bid for them. The Exchange accepts bids and offers in the form of orders and attempts to match them:
- bids are submitted as buy orders;
- offers are submitted as sell orders.
Exchanges are also known as "venues", although Exchanges are not the only kind of trading venue.
Level 2 Order Books
The "liquidity" available in the LOB can be viewed in multiple ways. In this article, we present the liquidity in the LOB as a stack of "price levels", where each price level comprises one or more orders with the same price and side. This representation is known as a level 2 order book aggregated by price.
Consider the following LOB with two price levels:
| Level | Bid Qty | Bid Price | Spread | Offer Price | Offer Qty |
|---|---|---|---|---|---|
| 1 | 1 | 9649 | 2 | 9651 | 1 |
| 2 | 5 | 9648 | 5 | 9653 | 3 |
For each given price level:
- the quantity is the sum of all order quantities at that level;
- the "spread" is the difference between the bid and offer price.
The first level, or Top Of Book (TOB), shows the best bid and offer available in the order book:
- the bids are arranged in descending order with the best bid at the top;
- the offers are arranged in ascending order with the best offer at the top.
Limit Orders
The LOB gets its name from a standard order type known as a "limit" order; a LOB is essentially a book of limit orders.
The price on a limit order is known as the limit price. The limit price specifies the worst price at which the trader is willing to trade (highest for bids and lowest for offers). This article deals exclusively with limit orders, so the limit price is subsequently referred to simply as the price.
Resting Orders
A trade happens when a buy or sell order is matched with one or more pre-existing orders in the LOB. How an order behaves when it is not immediately filled varies between order types.
Limit orders may also specify how long they are "good for". If a limit order is good for a period of time, and it is not immediately filled, then it is placed in the LOB according to its side (buy or sell) and price. An unmatched limit order that is live or "working" in the LOB is known as a "resting" order. Order types that cannot rest in the order book are either immediately filled or cancelled.
The short-hand notation below will be used in proceeding examples to describe a limit order:
- BUY 2@9650
- a buy order where 2 is the order quantity and 9650 is the price.
If this limit order is applied to our earlier example, then it will rest at the TOB on the bid side, because its price is better than the current TOB:
| Level | Bid Qty | Bid Price | Spread | Offer Price | Offer Qty |
|---|---|---|---|---|---|
| 1 | 2 | 9650 | 1 | 9651 | 1 |
| 2 | 1 | 9649 | 4 | 9653 | 3 |
| 3 | 5 | 9648 |
Similarly, a limit order to "SELL 3@9653" will "join" the second level on the offer side:
| Level | Bid Qty | Bid Price | Spread | Offer Price | Offer Qty |
|---|---|---|---|---|---|
| 1 | 2 | 9650 | 1 | 9651 | 1 |
| 2 | 1 | 9649 | 4 | 9653 | 6 |
| 3 | 5 | 9648 |
Note that the number of orders at each price level cannot be derived from the aggregate quantity. The order count is often shown as a separate "count" field.
Order Matching
In a classic LOB, Matching happens by price/time priority. This means that orders are matched first by price, and then by time (order age). If multiple orders exist at the same price level, for example, then the oldest order will be matched first.
Consider the effect of a limit order to "BUY 2@9652" that crosses the spread:
| Level | Bid Qty | Bid Price | Spread | Offer Price | Offer Qty |
|---|---|---|---|---|---|
| 1 | 1 | 9652 | 2 | 9653 | 6 |
| 2 | 2 | 9650 | |||
| 3 | 1 | 9649 | |||
| 4 | 5 | 9648 |
In this example, the limit order to "BUY 2@9652" crossed with the first level on the offer side ("OFFER 1@9651"). The price on the order was higher than the level it crossed, so the resulting trade will have an improved price of 9651.
The limit order was not completely filled, because there was insufficient quantity on the offer side. And assuming this order is good for some time, any quantity remaining after the matching phase is complete will rest on the bid side, hence the new price level on the bid side at TOB.
Orders that cross the spread and "take" liquidity from the order book are known as an "aggressive" orders. By contrast, orders that do not cross the spread are known as "passive" orders.
Aggressive orders may "sweep" through multiple price levels, as demonstrated in the following example, where an aggressive order to "SELL 4@9649" sweeps through the top three levels of the bid side:
| Level | Bid Qty | Bid Price | Spread | Offer Price | Offer Qty |
|---|---|---|---|---|---|
| 4 | 5 | 9648 | 5 | 9653 | 6 |
This aggressive order will result in the following trades:
- 1@9652
- 2@9650
- 1@9649
Makers and Takers
Traders that submit aggressive orders are known as "takers". Traders that submit passive orders are known as "makers". Market-makers play an important role in providing liquidity to the market, because, under normal market conditions, they are willing to quote two-way prices on a continual basis, thus ensuring that there is always a maker available to take the opposing side of a taker's trade.
Each trade transaction comprises two matched orders. These orders can be classified both in terms of a buyer and a seller or a maker and a taker. To avoid confusion, trades are often referred to from the taker's perspective as "paid" or "given":
Paid: taker bought or "lifted the offer".
Given: taker sold or "hit the bid".
This terminology is particular relevant for public trade feeds, where an Exchange may publicise anonymised trade information from the taker's perspective.