Backtest MasterClass — Part 5
Understanding the Order Book
There’s no doubt that new traders can get easily confused when first getting introduced to the crypto markets. Between the candlestick charts, depth charts, volume, moving averages, etc. all cluttering the screen, things can be a bit confusing. But what about all those numbers on the side? You probably already know and see all the recent trades going on in the market, but you’ve likely also seen a stack of numbers, prices, and quantities with little movement just sitting there. What is that? It takes two to tango in the world of crypto trading, where a dynamic relationship between buyers and sellers is always on display in something called an order book. In this post, we’ll show you how to read this powerful tool that will help you understand a token’s supply, demand and gain insights into the moves you can make in order to have a fair exchange or even turn a profit. We’ll be covering the following topics:
- What is an Order Book?
- Components of an Order Book
- Order Matchmaking
- Understanding the Order Book
- Order Patterns
- Dark Pool
What is an Order Book?
Order Book is a tool that visualizes a real-time list of outstanding orders for a particular asset, order books represent the interests of buyers and sellers, offering a window into supply and demand. But while all order books serve the same purpose, their appearance can differ slightly among exchanges. That said, they are all built with the same features and functions.
It looks like an electronic list of buy and sell orders for a specific security or financial instrument organized by price level. An order book lists the number of tokens being bid on or offered at each price point, or market depth. A matching engine uses the book to determine which orders can be fulfilled i.e. what trades can be made.These lists help traders and also improve market transparency because they provide valuable trading information. An order book is dynamic, meaning it’s constantly updated in real-time throughout the day.
Components of an Order Book
The outline of an order book can vary between the recorded securities. However, it usually consists of several components, as listed below:
1. Buyer’s side and Seller’s side: An order book is a market price recorder. Therefore, it includes a buyer’s side and a seller’s side — the two major participants in a market.
2. Bid and Ask: Instead of using a buyer’s side and a seller’s side, some order books use the terms “bid” and “ask.” Buyers are the ones who “bid” for a certain number of tokens at a specified price, and sellers “ask” for a specific price for their tokens. As a rule of thumb, the buyer’s side (bid) is on the left, and the seller’s side (ask) is on the right, colored green and red, respectively.
3. Prices: An order book records the value interest of both sides. The number in the buyer’s or seller’s columns represents the amount they are bidding or asking for, and at what price.
4. Total: The total columns are the cumulative amounts of the specific security sold from different prices.
5. Visual demonstration: Normally, an order book comes with a table of numbers consisting of prices and total amounts from two sides. To better represent the relationship between buyers and sellers, most of the order books come with a visual demonstration as well. It can be in the form of a line chart or others. In this way, the reader can quickly achieve an overall understanding of market demand and supply.
Practical Example
The image above showcases the buyers on the left (bid) and the sellers on the right (ask).
Example: On the buyer’s side, 778 units are being sold at a price of 7,500. On the seller’s side, 518 units are being sold at 7,600. The order book is filled with units being sold at other varying price levels as well. We can see that the total amount is accumulated depending on different price levels. For instance, on the buyer’s side, at a price level of 6,872, the amount is 49,500. It is added by the previous bidding offer of 20,000, and the current one at 29,500 (20,000 + 29,500 = 49,500).
We see Binance has a similar setup. The top portion of the order book shows who is selling BTC, what price they’re selling at, and how much there is on the market at that price point. On the bottom portion of the order book, we see who is willing to buy BTC in the markets at a specific price and how much the market is willing to buy at that price in total.
The following are the price types that you can spot in an order book:
- Bid Price: The highest posted price someone is willing to buy an asset.
- Bid Size: The number of tokens that people are trying to buy at the bid price.
- Ask Price: The lowest posted price someone is willing to sell an asset. Also called the “offer price.”
- Ask Size: The number of tokens being sold at the ask price.
- Last Price: The price at which the last transaction occurred.
- Last Size: The number of tokens involved in the last transaction.
The top of the book is where you’ll find the highest bid and lowest ask prices. These point to the predominant market and price that need to get an order executed.
Order Matchmaking
Even after learning what each component of an order book means, reading one can still be overwhelming. The numbers change at an incredibly fast pace and, if you don’t know what’s happening behind the scenes, you might still be confused as to your next move.
When you see the numbers on an order book change, it means orders are being filled or canceled in the backend. Those changes are reflected in the order book in real time. That process is called matchmaking, and it refers to the automatic placement of your offer to its counterpart.
Here’s an example. Say you want to sell 1 BTC for 9000 USD. The order will appear on the sellers’ side of the order book. Now, if someone on the buyers’ book wants to buy 1 BTC for 9000 USD, the matchmaking mechanism will grab your order and complete it with the buyer’s order. After that, both orders will disappear from the order book. This mechanism works through a First-In-First-Out principle — the first orders placed are the first orders matched.
Understanding the Order Book
Being able to see the last price a token was exchanged for, the number of tokens waiting to be bought/sold at a specific price, and the spread between the buyers’ and sellers’ sides, allows you to make an informed decision. With this, you can make your own analysis, predict the next movements on a token’s price and — most importantly — place your orders at the right time so that you can maximize the value of your trade.
Order Patterns
Order patterns are perhaps the most complicated aspect of order book reading, as they illuminate much of the manipulation that occurs in altcoin markets. Whilst we won’t go into the more advanced stuff here, it is significant to highlight the four types of order pattern: clean orders, bot orders, walls and, for lack of a better term, non-clean orders or messy orders.
- Clean Orders: A clean order is simply an order that is unusually perfect, mathematically. These are often orders consisting of multiples of 5s or 10s that occur at regular intervals in the orderbook.
- Non-Clean Orders: Much like clean orders, non-clean orders are about determining symmetry and patterns in the orderbook. However, they are more difficult to notice, as, unlike their clean counterparts, they consist of seemingly random numerical values. Non-clean orders are simply a more discrete way for market manipulators to mark out significant levels for future reference.
- Bot Orders: A bot order is one that defies human ability in its execution. Often, algorithms are in place to bid up a buy order or push down a sell order. This is easily noticeable and you have likely experienced it yourself. Recall a time when you’d place a buy order at the top of the orderbook, only for it to be displaced within milliseconds by another buy order; this is a bot order.
- Walls: Most are familiar with walls. A wall is an unusually large order in the order book. However, most tend to react in the most irrational manner when it comes to these orders. Large buy orders being pushed and pulled near current prices are often viewed by the masses as the perfect time to enter, lest one miss out on what must be an imminent bullish move. Large sell orders are viewed as the perfect time to exit, lest we lose all our money when the market crashes and burns. This is order book manipulation at its finest. Buy walls are an attempt at causing irrational market participants to buy up the orderbook, and vice-versa for sell walls. This allows for better pricing to be had for the puppet-master for both accumulation and distribution purposes.
Note these various orders down as and when you come across them — and you will come across them — and you’ll begin to piece together a trail of footsteps that must be left by those manipulating price and can help you make trading strategies which can outmaneuver these market manipulations.
Dark Pools
Although the order book is meant to provide transparency to market participants, there are some details that aren’t included in the list. Among these are “dark pools.” These are batches of hidden orders maintained by large players or institutional investors who do not want their trading intentions known to others.
Without dark pools, exchanges would see significant price devaluation. When information about a big transaction by a large institution is made public before the trade is executed, it normally leads to a drop in the price of the security. But if information about the transaction is reported after it takes place, the impact on the market may be significantly lowered.
The presence of dark pools reduces the utility of the order book to some extent since there is no way of knowing whether the orders shown on the book are representative of true supply and demand for the stock.
Conclusion
Although technical analysis is sometimes enough to trade off, it is important to keep in mind that people, not patterns, move the markets and spotting a pattern is just one step in the process of identifying a trade. There is always a two-way bet going on any pattern and watching order flow can show the probability in which direction it will break. In a market notorious for trade washing, getting a feel for spoof orders will only come with time and familiarity watching the book.
Checkout the rest of the articles if you haven’t already!
- Part 1: Understanding the Backtest Report
- Part 2: Getting better at Sharpe Ratio
- Part 3: Understanding Maximum Drawdown
- Part 4: Stop-Loss and Take-Profit
- Part 5: Understanding the Order Book
Until next time!
Links
A few quick references below:
· Signup now on Mudex and get $25 FREE: https://mudrex.com/signup
· Support and FAQs: https://support.mudrex.com/hc/en-us
· 24*7 support on our Discord channel: https://discord.gg/huZz3qP
Happy Trading!
Originally published at https://blog.mudrex.com on June 27, 2020.
