central limit order book

Learn this limit order book trading strategy if you want to keep up with the sophisticated high-frequency trading machines. The purpose of this order book trading guide is to teach you how to trade an order-driven market. We’ll explain to you the limit order book and the nitty-gritty of reading the order book.

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Most people start their trading careers by studying historical price data and charts. After all technical analysis strategy is the most widespread form of analyzing the markets, be it stocks, bonds, currencies, or even cryptocurrencies.

Market technicians try to forecast future market trends by studying price action as compared to order book trading which relies on studying the limit order book to predict the price. Once technical traders are getting into the essential part of submitting orders, that’s when they will run into trouble.

The stock market order book will allow everyone to understand what’s going on behind the scene. At first glance, the order book might look intimidating because they have a lot of things going on like changing numbers and flashy indicators that make it harder to keep up if you never used an order book before.

We’re going to start the ball rolling and explain what is order book, how does the order book work, how order changes affect the order book and last but not least a simple limit order book trading strategy that you can use today.

What is Order Book?

the order book

Put it simply, an order book is an electronic bookkeeping system of all buy and sell orders for a particular instrument (stock, futures, bonds, cryptocurrencies, etc.) that includes multiple price levels. Basically, when you look at the order book, you get a visual representation of the order flow trading strategy.

The order book is also known as the limit order book (LOB) or central limit order book (CLOB).

Each stock exchange (NYSE, NASDAQ, etc.) has its own order book for each security that they trade. For example, for every stock listed on the New York Stock Exchange, there is a limit order book.

When someone wants to trade a stock they will submit a limit order to an exchange. The order book will display the following information about the limit order:

  • The security symbol or stock ticker to tell the exchange what security they want to trade.
  • The order direction, whether they are interested to buy or to sell that particular stock.
  • The limit price, which represents the price they would like to trade.
  • The size, which represents the number of shares or contracts that they are willing to buy or sell.

These four things come together to form the limit order:

  • Buy limit orders (Bids).
  • Sell limit orders (Asks or Offers).

Understanding these outstanding limit orders is the most important part of order book trading. Check out our guide on the buy or sell signal.

So, we’re going to share a few reasons why you should use the stock order book.

See below:

Why You Should Try Order Book Trading

stock market order book

First, if you gravitate towards short-term trading the order book is mostly “responsibly” for the price action.

Let me explain…

The supply and demand imbalances that are showed on the order book can provide traders with signals to short-term price changes. So day traders and scalpers will find the order book extremely useful. So, the shorter the time frame you use the more important the order book is.

Now, here is the complete list of reasons why we like this style of trading:

  • The real advantage of order book trading is that it has a fast-paced learning process. Through repetition, the better you will get at it.
  • A psychological advantage is that you’ll become a pro at taking losses. It will be just part of the game so the pain of taking losses will disappear. Learning how to manage losses in trading is the biggest hurdle for many traders especially beginner traders.
  • The order book forces you to trade what you see and not what you think. When you spot an order book trading opportunity you’ll have to make a split-second decision to get into the trade.

In our experience, the skills that you’ll develop in order book trading will set the stage for bigger and better things in your development as a trader.

Moving on…

Let’s get a little bit deeper and see how orders affect the order book.

See below:

How Limit Orders Affect the Order Book

First, you should know that limit orders are arranged by the exchange on a price-time priority. In other words, orders are organized in the book according to price from highest to lowest for the bid prices and from lowest to highest on the ask side.

All new limit order strategies that are submitted to the stock exchange will go into the order book and get sorted out according to this logic.

See the limit order book below:

order book trading

Moving on…

We will like to outline the steps of building up an order book.

For simplicity let’s assume we have a completely empty order book with no bids and ask printed.

The first thing we’re going to do is to add a limit order.

For example, if a trader submits a limit order to buy 400 shares of Facebook (FB) at 250.40, the broker will submit to the exchange the stock they are buying, the direction, price and the order size.

The exchange will also add an order number and the time it was submitted.

Since there are no other orders on the book the limit order will go up to the top of the book on the bid size.

The central limit order book will look something like in the figure below:

limit order book trading strategy

Moving on…

Another limit order gets submitted to the exchange.

This time the order is to buy 1,000 shares of FB, but they are only willing to pay 250.35.

So, this bid price is lower than the first one, which means it will go lower on the order book.

Given, our time price priority this order will be placed at Level 2 on the book.

See the limit order book below:

limit order book

Next…

Another limit order gets submitted on the exchange.

This time, the limit order is to sell 600 shares of Facebook at an asking price of 250.46.

Because this is a sell order forex is going to go to the Ask side of the order book.

See the order book below:

order book trading

Moving on…

A fourth limit order is submitted to the market.

This order is to buy 200 shares of FB at 250.40.

Can you predict where this order is going to go into the order book?

If we check out the order book, we can see there is already an order submitted.

So here is the thing that will happen:

Since the order book matches the best bid price but arranged on a time priority too, it means this fourth-order will go on Level 2. In this case, the order O102 will be moved down, and then order O104 will replace O102 on the book.

See the order book below:

limit order book example

You can see how the order O102 was pushed down and replaced by O104, due to the price-time priority.

Next…

Another order comes into the exchange to sell 400 shares of FB at an asking price of 250.44

Can you predict where this order is going to go into the order book?

We can see it improves on the best asking price so it’s going to be placed on the top of the book over the previous sell order. The order O103 will be pushed down and replaced by the new order O105, which is now sitting at the top of the book.

See the limit order book below:

order book explained

The limit order book is now set up with 5 orders in it.

If you really wanted to buy some 200 shares of FB stock you would be able to purchase because there is enough liquidity. In other words, there is a willing seller ready to take the other side of your transaction.

The reason why we can purchase FB stocks is that there are people who have put limit orders on the order book. So, each time a trader puts a limit order into the market they’re adding liquidity. The liquidity allows buyers and sellers to trade in that market.

The top of the book is a key part of the order book because it shows you the highest bid or the best bid and the lowest ask price or the best asks.

You will be able to learn how to use the limit order book fairly quickly.

Moving on…

Let’s explore a limit order book trading strategy that anyone can use to further confirm your trades.

See below:

Limit Order Book Trading Strategy

What we want to explore is a manipulation of the order book that takes place very often.

There is a situation that happens quite often with the order book, namely canceling orders. This is something known as spoofing the limit order book.

Now, you might be wondering:

What is spoofing?

In simple terms, spoofing is the process of submitting large sell or buys limit orders added on the order book but with no intention to want to get filled on that particular order.

The purpose of spoofing is to manipulate the market price and create a false depiction of liquidity in the market. By doing this, the smart money is trying to manipulate one side of the order book (buy side or sell side) and convince other market participants to join the market on the same side.

However, once enough traders bite the bullet, the large order gets canceled and never gets filled; but instead, the smart money is switching sides and go on the opposite side of the initial limit order.

Here is an example of spoofing on the order book:

Let’s assume you’re a big player and want to buy 5,000 shares of Tesla at $445 but the current price of Tesla shares is at $450. To spoof the market, the big player needs to create a false impression of a major seller order coming into the market. In this regard, he posts a significant sell order at $449 and then further down into the order book to $446.

This will mislead other traders and high-frequency robots to believe there is a real interest to the downside. Once other market participants join in the market and sell, the price will start dropping.

However, our big player will start canceling his “fake” sell orders before they get the chance to be executed, instead, he ends up with his initial stake of 5,000 shares that he intended to buy.

Next…

As soon as the market realizes there is no real selling interest.

Keep in mind that all the “fake” sell orders never got executed, which means that the sell-side has sharply decreased and revealed that there is no big seller anymore. This will cause the Tesla shares price to rise again and to return to the previous equilibrium price of $450.

This in a nutshell describes spoofing.

You have to keep in mind that to execute these types of orders you need an algorithm to cancel your “fake” order right before it gets the chance to be executed.

Your job is to train your eyes to spot this kind of spoofing activity and take advantage of it. Keep in mind that spoofing is an illegal activity, but it’s still happening in today’s markets.

Final Words – Order Book Trading

In summary, the limit order book can be used as an additional trading tool in your trading toolkit. Most successful short-term traders in the world use order book trading. So, if you’re a day trader or scalper it’s crucial to use the order book considering that every small price change can make a big difference.

So, here is what you’ve learned:

  • How to read the limit order book.
  • Order book trading has 3 major benefits among which the most important is that you’re forced to trade what you see, not what you think.
  • How limit orders affect the order book.
  • Spoofing – a limit order book trading strategy used by big players to manipulate the price.

Thank you for reading!

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