What is Order Book? The Complete Guide to Order Book Market Making Tools

Financial markets in general and Crypto markets in particular are formed and built based on several invariable rules and tools, among which the Order Book is one of the backbones of financial markets, an extremely important tool that helps financial and cryptocurrency transactions be executed. So what is the Order Book? Let's explore this with Allinstation in this article.

What is Order Book?

An Order Book is an electronic list displaying buy and sell orders sorted by price, providing investors with detailed information about market supply and demand. This allows them to make smart trading decisions based on the actual market conditions.

Suppose the best (highest) buy price at that time is 50 tokens at $50 per token. The algorithm will execute this part of the sell order for 50 tokens of B at $50 per token. If the next best buy price is for 75 tokens at $49, the algorithm will sell the remaining 50 tokens of B at $49 per token. This flexible process ensures that market orders are executed at the best possible price at any given time.

A practical example demonstrating order matching

BTC is priced at $50,000

You observe the Order Book and see that there are very few sell orders at prices above $51,000 - $52,000, but sell orders are densely placed at $55,000 => At the moment you view this, you can draw the insight that the likelihood of BTC rising to $55,000 is very high because there are very few sell orders in the Order Book between $50,000 - $55,000. However, the Order Book only shows automatically set limit "orders" by investors, so it is entirely possible for them to withdraw orders and execute a market sell order at a different Bitcoin price.

=> This shows that the order book is only a useful tool in the short term and should not be completely relied upon for long-term trading because "Sell Wall" - "Buy Wall" can be removed at any time

Buy Wall and Sell Wall in Order Book

Buy Wall (Bid Order Book): The buy wall is where investors and users place Bitcoin buy orders at specific prices and quantities. This is part of the order book on exchanges, allowing users to see the prices at which others want to buy Bitcoin and the corresponding quantities. Buy prices are usually arranged from highest to lowest.

Example:

Price level $35,000: User A wants to buy 5 BTC.
Price level $34,000: User B wants to buy 3 BTC.
Price level $33,000: User C wants to buy 7 BTC.

Sell Wall (Ask Order Book): The sell wall is where investors and users place Bitcoin sell orders at specific prices and quantities. Opposite to the buy wall, this is where users can see the prices at which others want to sell Bitcoin and the corresponding quantities. Sell prices are usually arranged from lowest to highest.

Example:

Price level $36,000: User X wants to sell 2 BTC.
Price level $37,000: User Y wants to sell 4 BTC.
Price level $38,000: User Z wants to sell 6 BTC.

Types of Orders

There are several types of orders that traders can place in the order book, each serving specific needs and strategies.

1. Market Order: This is an instruction to buy or sell a financial instrument at the best available current market price. Market orders are prioritized and usually executed quickly, but the final execution price is not guaranteed and can fluctuate, especially in rapidly changing markets. Here, speed is more important than price.
2. Limit Order: A limit order is an instruction to buy or sell a financial instrument at a specific price or better. For example, a buy limit order can be placed at the current market price or lower, and a sell limit order can be placed at the current market price or higher. Unlike market orders, limit orders are not guaranteed to be executed but allow traders to control the execution price.
3. Stop-Loss Order: Also called a 'stop-loss' order, this is an order to buy or sell a stock when it reaches a specific trigger point, with the intention of limiting an investor's loss. This order becomes a market order when the trigger price is met or exceeded.
4. Other Order Types: More complex orders serve experienced traders, such as All-Or-None (AON) Order, Fill-Or-Kill (FOK) Order, and Immediate-Or-Cancel (IOC) Order. These order types come with specific conditions and are often used to manage trading risks and rewards.

Characteristics of Order Book

Order Book is an immutable tool applied to most CEX exchanges in crypto, so the characteristics of the order book also partly constitute the trading characteristics of the market.

Depth and Spread – Two Sides of the Same Coin

The two main indicators showing an asset's condition in the orderbook are depth – the number of open buy and sell orders – and the spread between the best buy and sell prices. These two factors work together to provide a summary picture of the liquidity and market sentiment of a financial instrument.

For example, a narrow spread (small difference between buy and sell prices) combined with high depth (many BTC quantities) at these price levels often indicates a highly liquid market with strong competition among traders, thereby reducing transaction costs. Conversely, a wide spread combined with low depth may indicate low liquidity and high volatility, leading to higher transaction costs and making it easier for MMs to drive the price, with token prices having 20-30% Pump - Dump movements.

If reading the order book from the image, we can see that the buy-side liquidity is very high and the sell walls are thick, while the sell-side liquidity and sell walls are very low => the price will tend to easily go up if someone executes a buy order and fills the entire 8.92 quantity in the quantity column, the price will rise to 11632.9

=> By reading the order book, we can somewhat predict how much Market Makers will need to push the price to a certain level.

Price-Time Priority Rule

A core rule for order book operation is the Price-Time Priority Rule. This rule means that the order with the highest buy price (for buyers) + earliest or lowest sell price (for sellers) + earliest will be executed first. If two orders have the same price, the order placed first will be prioritized.

This rule is crucial to maintain market fairness, ensuring that each market participant, regardless of their trading size or strength (in terms of money, order volume, etc.), follows the same set of rules. It keeps the market democratic and equal, helps prevent potential manipulation, and supports market integrity.

Real-Time Nature of Order Book

The order book operates in real-time, continuously updating to reflect the current market condition. This dynamism is extremely important for its role in the market, ensuring that traders get the latest information, especially in a volatile market like Crypto. Data from the order book allows participants to maintain sensitivity to market trends and sentiment.

A simple example is that when a token shows signs of preparing to pump, observing the order book can help us somewhat sense the token's next move, whether it will continue pumping when encountering a sell wall, because when a token pumps, the sell wall will be removed before pumping to avoid being sold down. Observing this combined with other factors will help us make more accurate decisions.

Deep understanding of how order books work helps traders use them more effectively. It provides insights into ever-changing market dynamics and provides a framework for predicting potential price movements and planning accordingly.

How to Read and Analyze Order Book

To effectively decode the valuable information contained in the order book, one needs a comprehensive understanding of market dynamics, order book structure, and attention to detail.

Understanding Buy and Sell Volumes

Beyond the best buy and sell prices, examining the volume of orders at these prices is crucial. Large volumes at the best buy or sell prices can act as temporary support and resistance levels, indicating a potential trend reversal or continuation of the current price trend.

Moreover, by assessing order volumes at different price points in the order book, traders can evaluate market liquidity and potential asset volatility.

For example:

A deep order book, with a large number of buy and sell orders distributed evenly across different price levels, often indicates a highly liquid market that can accept large trades without significantly affecting the price.

Conversely, a thin and low order book may indicate lower liquidity, leading to higher price volatility as even small trades can change the price.

However, orders on the Order Book are not 100% certain and can be canceled at any time.

Identifying Order Clusters

Searching for order clusters at specific price levels can provide insights into market movement. A large buy order cluster may indicate strong support, and a large sell order cluster may predict higher selling pressure on the price.

Where Are Order Book Market Making Tools Commonly Used?

Order Book is typically used on CEX platforms where liquidity is most concentrated, such as Binance, OKX, Bybit, etc., with a price-matching mechanism that makes liquidity more abundant and smooth in order matching. Market Makers often have specific strategies with order books, usually placing buy and sell walls or even using bots to trade and create liquidity more easily.

The Order Book mechanism has also appeared on decentralized exchanges (DEX), although not as common as the AMM mechanism, but some DEXs still choose the order book mechanism to simulate the CEX experience, such as dYdX, Aevo, Injective,...

Summary

Order Book is an extremely important tool in the complex world of financial markets. It not only provides a snapshot of market psychology but is also an important source of information for traders to make smart decisions. By deeply understanding how order books work and analyzing the information contained within them, traders can optimize their trading strategies and leverage market opportunities.