An Introduction to Limit Order Books

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2021-07-21 17:00:11

Throughout the time I have spent working in the industry, I’ve often been asked the question of how exactly trading works. While to those in the know this might seem obvious, I have found that quite frequently the concept of how order books and trading actually work, is not well understood.

In this article I want to go into the concept of Limit Order Books and their operation. Starting from the absolute basics, and later going into some of the more advanced features. In addition, I will try to define relevant terminology and shorthand where appropriate.

In any functional market, there must be both buyers and sellers. Just as in any farmers market, in a stock (or any securities) market there are both the buyers (customers coming to buy) and sellers (the merchants in the stands) willing to make a trade (buy/sell produce) at a price that makes sense to them.

This can be visualised in real life by looking at the recent PlayStation 5 shortage and the consequences on the price. Since there is a very limited supply of PS5’s (low liquidity) the more people that buy, the more the price starts to go up. Indeed, the very fact that there were so few available, caused scalpers to take already bought playstations, and offer to sell them again at an exorbitant price. Because there are not enough products to satisfy demand, any purchases will reduce the number available even further, meaning that the remaining products will become even more expensive to buy.