What Is an Order Book?
In the stock market, an order book is a tool that provides information about the current orders to buy and sell a specific asset and their prices. The order book displays these orders in the form of a table or chart and is usually divided into two parts:
- The upper half: sell orders
- The lower half: buy orders
In the order book, you can see the following information:
- Price: This is the price at which a seller or buyer is willing to execute a transaction.
- Volume: The quantity of assets that a seller or buyer wishes to buy or sell at the specified price.
- Total Volume: The sum of all orders at a given price.
The order book allows you to see the prices offered in the market and the volume of assets available for purchase or sale at a specific price. This information is useful for making decisions about when and at what price to execute a trade. Traders can use the order book to analyze the current market situation and determine the optimal timing for entering or exiting a position, as significant clusters of orders at a particular price level can indicate potential strong resistance when the price reaches those levels.
What Is a Limit Order?
A limit order is a type of order in the stock market used for buying and selling at a specific price. An important characteristic of such an order is that it is executed only at the specified price or a better one, but not at a worse price.
Here’s how a limit order works:
Limit order to buy:
- A trader specifies the maximum price at which they are willing to buy an asset.
- If there are sellers in the market willing to sell the asset at a price equal to or lower than the price specified in the limit order, the transaction is executed.
Limit order to sell:
- A trader specifies the minimum price at which they are willing to sell an asset.
- If there are buyers in the market willing to buy the asset at a price equal to or higher than the price specified in the limit order, the transaction is executed.
Limit orders allow for more precise control over the price. However, it’s important to understand that limit orders may not be executed immediately or at all if the specified price is not achievable in the market. Because of this, while limit orders require less real-time monitoring of the market, you still need to keep an eye on the situation.
What Is a Market Order?
A market order is a type of order that is executed immediately at the current market price. When a trader places a market order, they indicate that they want to buy or sell an asset right away. Such an order guarantees execution but does not guarantee a specific execution price.
Key characteristics of a market order:
- Immediate Execution: A market order is executed immediately, right after it is placed. If it’s a buy order, it will be bought at the current market price; if it’s a sell order, the asset will be sold at the current market price.
- Execution Guarantee: A market order ensures that the trade will be executed, but it doesn’t guarantee a specific execution price. This means that in rapidly changing markets, the execution price may differ from the price visible at the time of placing the order.
- Suitable for liquid markets: Market orders are ideal for liquid markets where trading volume is high, and the bid-ask spread (the difference between buying and selling prices) is small. The less liquid a market, the higher the likelihood of price disparities when placing and executing an order.
Market orders are often used by traders who need to enter or exit positions quickly without delays.
What Determines Order Execution Speed?
The speed of order execution on the stock exchange depends on several key factors:
Market liquidity
Market liquidity indicates how quickly you can buy or sell an asset at the current price without significantly affecting that price. In highly liquid markets with many participants and high trading volume, orders are executed quickly because there are always buyers and sellers. In less liquid markets, orders may be executed more slowly as suitable counterparties must be found.
Order type
As discussed earlier, different order types have different execution characteristics. Market orders are executed immediately, while limit orders are executed only at or better than the specified price.
Order size
Larger orders, such as substantial purchases or sales of assets, may take more time to execute, even in a liquid market. This is because large orders can impact the market price, and execution may be spread out over multiple transactions.
Market volatility
Market volatility refers to the price fluctuations in the market. In periods of high volatility, market orders may be executed quickly, but the execution price can differ significantly from the current market price. This is particularly important in markets like cryptocurrencies and stocks, which can experience rapid price movements.
Technological infrastructure
The brokerage firm or exchange where the order is placed has its own technological infrastructure that can significantly affect order execution speed. The efficiency and speed of this infrastructure play a crucial role in how quickly orders are executed.
These factors collectively influence how fast an order is executed in the stock market. Traders must consider these factors when choosing the type of order and the timing of their trades.
Mechanism of Market Price Formation on the Exchange
The mechanism varies depending on the type of exchange. The difference lies in different approaches to price formation.
Centralized exchange (CEX)
The mechanism for forming the market price on a centralized cryptocurrency exchange follows general principles of market economics but has its own characteristics related to the nature of cryptocurrency markets. Here’s how the market price is typically formed on a centralized cryptocurrency exchange:
Orders to buy and sell
Market participants, known as traders, place orders to buy and sell. These orders can be market orders (buying/selling at the current market price) or limit orders (buying/selling at a specific price). When a buy order matches with a sell order, a transaction occurs. The price of the transaction is determined by the level at which these orders matched. This is called “order execution.”
Price dynamics
The market price changes based on the dynamics of supply and demand. If demand outweighs supply, prices may rise, and vice versa.
Trade volume
The more orders are placed at a specific price, the more significant it becomes. A higher volume can indicate support or resistance levels.
Liquidity
More liquid markets tend to have narrower spreads between buying and selling prices.
Exchange role
Centralized exchanges match orders, ensuring transparency and reliability in the process. They may also establish trading rules, control asset listings, and ensure transaction security.
Volatility
Cryptocurrency markets are often characterized by high volatility, leading to rapid price changes over short periods. This is important to consider when trading on such markets.
The mechanism for forming market prices on centralized cryptocurrency exchanges can also be influenced by other factors, such as news, events in the crypto space, regulations, and market manipulation. Nevertheless, the core remains the interaction of supply and demand based on orders from market participants.
Decentralized exchange (DEX)
The mechanism for forming market prices on a decentralized cryptocurrency exchange (DEX) is largely similar to centralized exchanges but with differences related to the decentralized nature of such platforms. Here’s how the market price is typically formed on a DEX:
Liquidity pool
On DEXs, transactions occur within liquidity pools. Liquidity depends on the volume of assets added to the pool. The larger the assets, the more liquid the pool, and the less likely significant spreads are.
Automated market maker (AMM)
DEXs typically use an automated market maker (AMM) instead of an order book. The AMM automatically sets the price based on the balance between two assets in a pair. When a trader places an order, the AMM calculates how many assets need to be exchanged at the current price to maintain balance. Calculations are done using formulas that may vary on different platforms.
Order matching
When a trader places an order on a DEX, it is matched with other orders in the liquidity pool. The transaction price is determined based on the current balance of assets in the pair.
Price dynamics
Similar to centralized exchanges, the market price on DEXs changes based on supply and demand dynamics. If more traders want to buy an asset than sell it, the price may rise, and vice versa.
Trade volume
Higher trading volumes at a specific price are more significant and can indicate support or resistance levels.
Volatility
Like centralized exchanges, cryptocurrency markets on DEXs can be highly volatile, leading to rapid price changes.
Decentralized protocols
Different DEXs may use different decentralized protocols, such as Uniswap, SushiSwap, PancakeSwap, and others. Each of them may have its own features in the mechanism of market price formation.
What is Slippage?
Slippage is a phenomenon in financial markets where the execution price of a trade differs from the price that was indicated at the time the order was placed. Slippage can occur both upwards and downwards and can impact the final results of trades, especially in active and volatile trading.
Upward slippage
When placing a buy order at a specific price, the trade executes at a higher price due to rapid market volatility. Such upward slippage increases a trader’s expenses and can reduce their profit.
Downward slippage
When placing a sell order at a specific price, the trade executes at a lower price due to a sharp price decline. This can reduce a trader’s revenue and increase their losses.
Slippage is often associated with market volatility and low liquidity. When the market is moving quickly or has low liquidity, order execution can be challenging, and prices may change by the time of execution. This is particularly relevant on cryptocurrency exchanges and during news events that can influence price movements.
To reduce the risk of slippage, traders use limit orders. However, in some situations, even limit orders can execute with slippage when the market moves too rapidly.
Why Orders May Fail to Execute
Not always does an order trigger and execute when the desired values are reached. Sometimes, orders don’t execute at all or only partially. There are several common reasons for this related to market characteristics and trading activity. Here are some of the most common reasons:
Lack of liquidity
If a market asset has low liquidity, it means there are few buyers and sellers in the market. In such conditions, a trade may not execute because there’s not enough counterparty interest.
Rapid price movements
If market prices change so rapidly that your order can’t trigger, it may remain pending or execute partially.
Exchange issues
Occasionally, exchanges face technical glitches or delays in order processing. As a result, your order may end up in a queue for execution, which can take time.
Minimum or maximum execution limits
Some orders may have limits on the minimum or maximum amount that can be executed in one go. If your order doesn’t meet these limits, it may execute partially.
Price gap
If the price of an asset moves between the time of order placement and execution, the order may execute at a different price than requested. This is called slippage.
Time constraints
Some orders have a limited time to live, after which they are automatically canceled. If your order doesn’t execute within this time frame, it will be canceled.
To reduce the risk of orders not executing as desired, traders can monitor market liquidity, use limit orders, place orders during periods of lower volatility, and thoroughly understand the rules and characteristics of the exchange they are trading on.
Difference in Trading on DEX and CEX
Trading on a decentralized exchange (DEX) and a centralized exchange (CEX) has significant differences in terms of structure, features, and principles. Here are the main differences between them:
Centralization vs. Decentralization
- On CEX, all orders and funds are stored and managed by a central organization (the exchange). Users create accounts on the exchange and trust it with their funds for trading.
- DEX operates on blockchain technology and lacks central control. Trading occurs directly between users, and they retain full control over their funds.
Liquidity
- Centralized exchanges typically have higher liquidity and higher trading volumes compared to DEX. This makes them attractive to large investors and traders.
- Decentralized exchanges may have lower liquidity for less popular trading pairs, which can lead to slippage and wider spreads.
Registration and KYC
- Most centralized exchanges require users to undergo Know Your Customer (KYC) procedures, which involve identity verification. This may require providing personal information and documents.
- DEXs do not require KYC. Users can trade anonymously without providing personal data.
Ownership of funds
- On centralized exchanges, users trust the exchange with their funds, which are stored in exchange wallets.
- On DEXs, users retain control over their funds, using non-custodial cryptocurrency wallets and owning private keys.
Security
- Centralized exchanges may be vulnerable to hacks and attacks, which can result in fund losses. They are also susceptible to internal fraudulent activities.
- Decentralized exchanges are less susceptible to hacks because they do not store user funds on central servers. However, users must still exercise caution and secure their own wallets.
Speed and fees
- Trading on CEXs usually occurs faster, and fees may be more predictable.
- Trading on DEXs can be slower due to the time required for blockchain transaction processing. Fees may vary depending on network congestion.
The choice between CEX and DEX depends on individual preferences and needs. Large investors and traders seeking liquidity and convenience may prefer CEXs, while users valuing anonymity and control over their funds may opt for DEXs.
What is an Automated Market Maker (AMM)?
An Automated Market Maker (AMM) is a computer algorithm used on decentralized cryptocurrency exchanges (DEXs) to provide liquidity for trading pairs. AMMs automatically create and manage liquidity pools of assets, allowing users to exchange cryptocurrencies and tokens without the need to find another participant to complete a trade.
Key characteristics of automated market makers:
Automated management of liquidity pools
AMMs automatically manage liquidity pools that contain assets (e.g., ETH and DAI). They automatically establish the exchange rate between these assets based on the principle of maintaining balance to ensure equilibrium between them.
The balance preservation principle
AMMs adhere to the balance preservation principle: the product of the quantities of assets in the pool always remains constant. For example, if there are 100 ETH and 10,000 DAI in a pool, the product of 100 * 10,000 always remains constant, even after trades are executed.
Collection of fees
AMMs collect fees from user-initiated trading operations. These fees can be used to reward liquidity providers who contribute their funds to the pools.
No need for third-party participants
Users can directly exchange through the pools without the need to find other participants to complete a trade. This eliminates the issue of a lack of counterparties in the market.
Decentralization
AMMs operate on the blockchain and do not require central control. They are based on smart contracts, ensuring transparency and security.
AMMs have become popular on decentralized exchanges such as Uniswap, SushiSwap, and PancakeSwap, contributing to liquidity provision for various trading pairs. They have also opened access to decentralized financial services and decentralized applications (DeFi) to a broader audience.