The fundamental principle of operation for all free exchange markets is the dynamic balance of supply and demand, based on which the market price of the asset being bought or sold is formed. A proficient analysis of this balance allows for predictions on the future price dynamics and aids in making the right decision on when to enter or exit a position.

In trading, there are numerous methods for such evaluation, but one of the simplest and most effective is the analysis of the order book, or the table of exchange bids (orders) for buying and selling stocks and other financial instruments.

What is an order book in the exchange

Generally, an order book is a table displaying all bids placed by participants in exchange trades in digital format. In English terminology, this is known as the DOM, or Depth of Market, which literally translates to «market depth» or «market snapshot».

These are the buyers’ bids, or bids (from the English bid — offer), and sellers’ asks (from the English ask — demand or request). Simply put, the order book is somewhat like a constantly updated list where sellers and buyers present their price options for the asset, as well as indicate the volume of transactions — the number of lots of stocks, bonds, currency.

If a seller’s and a buyer’s conditions completely match in both price and volume, the transaction is automatically executed and considered closed. However, if, for example, the price of a stock matches but the asset volumes do not suffice, such an order is considered partially executed.

The order will remain in such status until a counterparty is found who can offer to sell or buy the required volume of the exchange asset. This is how the market price balance is found, where the interests of the transaction participants match at the moment.

Previously, before the advent of electronic trading platforms, all participants’ bids were recorded by exchange brokers in a special book (order book) during the trading session. If some conditions matched in price and volume, the transaction was concluded during the daily or evening clearing. This is the time when final settlements between all parties of the exchange transaction are made.

Now, trading on the exchange can only be done in electronic settlement mode. Transactions between sellers and buyers, given the necessary parameters match, are automatically executed and instantly closed. Accordingly, the order book instantaneously records all traders’ orders. Each of them can set any price and any number of lots within the remaining funds or assets on the brokerage account.

The operation system of the order book is much like auction trading. A deal is made when the auctioned item finds its buyer under the most favorable conditions for the seller.

By observing bids in the order book, one can preliminarily see which direction the general interest of participants is leaning towards and make an informed decision regarding investments in the given asset. Thus, the order book can be considered an indicator of market sentiment during trading.

Purpose of the order book

Besides its primary function — finding buyers and sellers — the order book is used to achieve the following objectives:

• Ensuring trading transparency. All trades on exchanges are public, meaning open. This applies to information about companies — issuers of stocks, as well as data on the progress of trades. All market participants can at any moment see at what prices and in what volumes trades are happening for a given asset. This excludes cases of blatant market manipulations, as if trades were conducted in a closed mode.
• Gaining prompt information on the market situation. Monitoring bids gives every trading participant the opportunity to understand who is ready to buy or sell stocks at what price and in which direction the interest of major players is directed.

Therefore, the order book is a tool that allows a trader to decide whether to realize their potential for a deal now or wait for better conditions.

Types of orders in the order book

Exchange trading platforms’ regulations provide for several types of orders: limit, conditional, and market orders.

The types of orders available to an investor can be found in the tariff information on the broker’s website.

The order book displays buy and sell orders closest to the last recorded market price, equally from each side.

Structure of the market’s order book

The order book takes the form of a table with a specific structure.

Its central part is a combination of two parameters — buying (bid) and selling (ask) prices, — at which transactions are currently being made. This is the most crucial part of the order book, and it’s primarily what traders focus on.

As you move away from the central “bid” and “ask” values up or down, the price of orders increasingly diverges from the center. These are limit orders placed in the trading system by participants calculating that the price of the asset will move in their favor, waiting for their turn.

How to read the order book

Reading the order book always starts from its central part, with the price at which current trades are happening and orders are being executed.

Next, attention should be paid to adjacent columns of the table. Here, values closest to the center are recorded by orders waiting for their turn.

If large volumes for buying or selling are observed in one of the columns adjacent to the orders, it’s expected that the price will shift in their direction. Here, a simple rule applies: the price of an asset in exchange trades almost always follows larger volumes.

What to analyze in the order book

Key parameters for analysis in the order book:

• Volumes for listed orders. The larger the number of lots indicated in a deal, the higher the probability that the price of the asset will move in the direction of this bid. Large volumes are usually operated by major players who may have insider information and preemptively buy or sell assets.
• Price. If a price significantly different from others appears in the order book, this can also indicate a major player. Volume here will not always be an informative parameter — a market maker might use what’s called an iceberg order, where part of the orders is hidden.
• Repeated orders with a fixed price interval and identical volumes indicate the operation of an exchange robot in the order book. It evenly distributes orders across the entire order book, or, as traders say, “vacuums” the market (systematic buying), or, conversely, conducts an “allocation” of the asset (systematic sale).

Effectiveness of the order book: pros and cons

Analyzing the quantity and structure of the order book has the following advantages:

• Traders can see in real-time where the interest of other participants concentrates near a price. For example, if interest shifts towards selling while simultaneously increasing order volumes, it’s likely that stock quotes will decline shortly. This might be a good moment to buy the asset at a good discount.
• The dynamics of bids or transactions in terms of their volume provide an understanding of how ready participants are to buy or sell the asset. This allows assessing the liquidity of the instrument, i.e., the ability to quickly sell it at the market price.

The main disadvantage of the order book is that it’s impossible to precisely determine which orders are placed for actual transactions of the asset and which are fictitious.

Such fictitious orders — iceberg orders — are used to mislead other trading participants, often exploited by market manipulators. These are large speculative players wishing to change the asset price in their favor.