New on FinoLib · Volume III: Finance Encyclopedia
I have just published a new article on FinoLib, my free finance education library: Order Book Explained: How Order Types Work. It is part of Volume III: Finance Encyclopedia. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
5.1 The Order Book, Mechanically
The idea in plain words
An order book is a list of every waiting order. Buy orders, called bids, are listed by price, and sell orders, called asks, are listed too. The best bid and the best ask define the quoted spread and the midpoint between them. If your order is bigger than the shares shown at the best price, it walks the book: it fills at the best price and then at worse prices, paying more at each level.
Key points
■The midpoint is the average of best bid and best ask; the quoted spread is usually stated in basis points of the midpoint.
■Depth is the number of shares at each price, and displayed depth understates true supply because of hidden orders.
■In the worked example, a 3,000-share market buy averaged $50.0297 and cost about $59 (3.9 bps) against a $50.01 midpoint.
A closer look
Every modern electronic exchange operates around a central limit order book — a continuously updated, real-time list of every outstanding buy order (the bid side) and sell order (the ask or offer side) for a given security, ranked by price. The highest price any buyer is currently willing to pay is the best bid; the lowest price any seller is currently willing to accept is the best ask; the gap between the two is the bid-ask spread introduced conceptually in Capital Markets Part 3. A trade executes automatically the instant a new order’s price crosses and matches an existing order already resting in the book.
Decision rule
Compare your order with the shares displayed at the best price. If it is no larger than that size and the quoted spread is under about 10 bps, a market order costs roughly half the spread. If it is larger, or the spread is 10 bps or wider, use a limit order or split the order; above about 25 bps, use limit orders only. These are heuristics for liquid US stocks in regular hours; they do not apply in the opening and closing auctions.
The costliest mistake
Sending a large market order into a thin book. Had the book above held only the 800 shares at $50.02 with the next offer at $50.50, the same 3,000-share order would have paid 800 × 50.02 + 2,200 × 50.50 = $151,116, about $1,086 (72 bps) against the midpoint instead of $59. Thin books are common in small caps, just after the open and around news. Look at depth, and cap the price with a limit.
5.2 Order Types
The idea in plain words
Every type of order trades certainty of getting done against certainty of price. Market orders and stop orders will execute, but might fill far from the price you expected. Limit orders and stop-limit orders cap the price you will accept, but might not fill at all. It is like choosing between catching a train at any fare and waiting for a cheaper ticket that might sell out.
Key points
■A stop becomes a market order when its trigger trades, so it guarantees a trigger, not a price.
■Stop-limit, IOC/FOK, on-close and midpoint-peg orders each answer a specific need, at a specific cost.
■Clustered stops can turn a dip into a cascade, because each triggered stop is a new market sell order.
A closer look
Traders choose from several standard order types, each making a different trade-off between certainty of execution and certainty of price.
Decision rule
If you hold a position through earnings, overnight news or a market closure, assume a stop-market order can fill anywhere below its trigger, and size the position so that a gap of two to three times the stock’s typical daily move is survivable in ordinary conditions; through earnings or other binary news, assume a gap of 15% to 20% or more (the worked example below gapped 18%). Use a stop-limit only if you would rather keep the position than sell below the limit.
The costliest mistake
Treating a stop-loss as a guaranteed exit price. You own 1,000 shares bought at $100 with a stop at $95, expecting to lose at most (100 − 95) × 1,000 = $5,000. The stock opens at $82 after earnings and the stop fills at $81.90. Actual loss = (100 − 81.90) × 1,000 = $18,100, $13,100 more than planned. A stop-limit at $94 would not have filled at all, leaving an $18,000 paper loss still at risk. Only position size, or an option hedge such as a protective put, limits gap risk.
What the full article covers
In the full article I take you through these sections:
■5.1 The Order Book, Mechanically
■5.2 Order Types
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
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The complete article, Order Book Explained: How Order Types Work, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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