Basics of Order Book, Buyers and Sellers
Basics of Order Book, Buyers and Sellers
By the end of this article, you will understand this picture
Let's assume a music concert is organized in your city but you've missed the ticket sale. Shame! Lucky for you, the city organizes an event the day before the concert for people who want to buy or sell a ticket at the last minute.
You decide to go to the event..
You arrive among the first and 2 people are willing to sell their ticket. One sells at 54, the other at 53. We'll call these people "passive sellers" because they wait for you to buy the ticket at the price they have decided.
You keep searching for other sellers. Another one is willing to sell her ticket for 56. That's not really interesting yet you keep her offer in mind just in case.
That's how you build an order book. You find sellers, and you rank them from high price to low price.
If someone asked you "hey what's the price of a ticket to go to the concert?" you could confidently answer "That's 53". At least for now...
A guy rushes into the event's room, he is sweating, he wants to buy a ticket immediately. He goes to the passive sellers, finds the cheapest and buys the ticket at 53 in an instant. This is what we call "active buyers" They want to buy NOW!
When active buyers buy a ticket, they involuntarily make the price increase because the cheap passive sellers go away with them.
"Hey what's the price of a ticket to go to the concert?"
"... that's 54" for now...
Looking at this situation, you decide to become yourself an active buyer. You rush to the passive sellers and buy the ticket at 54 just before an old lady that looks at you with a grumpy face. You look at her with a smile: you should have been faster old lady!
You're so happy, you have your ticket, and you paid only 54! Your phone rings, you receive a call from your best friend. He wants to be sure you're ready to party with him on his birthday the next day. But that's concert day!
Oh crap! you're a loyal friend, you can't miss the birthday. But you have this ticket. What to do with it? Sell it of course!
You could decide to passively sell it but first you want to search who is willing to buy. You find 3 people willing to buy your ticket, one at 30, the second at 33 the last at 34. Guess who is willing to offer you 34 for your ticket.. the old lady!
You now complete your order book with the passive buyers side.
You don't want to sell your ticket at 34 (and lose 20) you prefer to become a passive seller and try to sell your ticket for the price you paid it at 54 to avoid any loss.
Unfortunately, in the meantime new sellers have entered the room and are selling their ticket for a cheaper price.
When new active buyers come in, they buy from these cheaper passive sellers not from you.
The clock runs and the event is almost over. Oh no! you must sell this ticket before the event ends or you'll lose all your money. Out of fear, you go to the passive buyers. The old lady is still the best passive buyer. She is waiting patiently with a very open and large smile. She says : "I'm willing to buy at 34". You take your ticket and reluctantly hand it over to her. She gives you 34 and conclude the transaction with a deadly "Happy to have done business with you".
She then peacefully leaves the event with her ticket while you go home angry, without a ticket and a loss of 20...
How the order book is built in real life
In real life all market participant gather together but never talk to each other directly, they instead talk only to the "exchange". The exchange is a computer system that gathers everyone's requests to buy or sell. It then builds the order book and shows it to you.
If you want to actively buy, the exchange will automatically match you with the best passive seller.
Thanks to the exchange you save a lot of time and have the guarantee you'll get the best price for your transaction.
Looking closer at the order book
What we see is that the order book is 2-sided, on the left-side we have passive buyers, on the right-side we have passive sellers.
If we are active buyers, we look at the bottom of the right-side to find the cheapest seller.
If we are active sellers, we look at the top of the left-side to find the highest offer.
The gap between prices in the order book
The distance between the best passive buyer price and the best passive seller price is called the "spread".
Spread is important because imagine you actively buy then actively sell immediately, the spread tells you how much money you will lose by doing this.
Why the distinction between active and passive is important
I always make the distinction because active and passive people have a different impact on the market:
- Active people can only MOVE the price
- Passive people can either MOVE or BLOCK the price
Active people
Let's look at an example with active people.
Active buyers move the right side of the order book UP while active sellers move the left side of the order book DOWN.
The consequence is that when active people buy or sell, they tend to increase the size of the spread.
Passive people
Now let's look at what happens when passive people enter the market.
On the left-side, 2 new passive buyers add their orders in the order book. Since their buy price is higher than 30 they move the price up. By doing so, they also reduce the spread.
On the right-side, 5 new passive sellers arrive and decide to sell also at 54. The total number of people who want to sell at 54 is now 6 people.
This accumulation of passive sellers at 54 in a sense "blocks" the price. To make the sell price go higher than 54, we need 6 active buyers to buy all those tickets at 54.
In our example we consider that each person has only one ticket to buy or sell, in real life a single person may have several tickets to trade so 1 passive seller could put in the order book 10 tickets to sell at 54 that would be absolutely valid.
Vocabulary
About the order book
| name | synonyms | definition |
|---|---|---|
| left-side of the order book | bid column | The column where all passive buyers price are put. Ordered by price |
| right-side of the order book | ask column | The column where all passive sellers are put Ordered by price |
| best passive buyer price | the "bid", "the offer", "buy price" | the highest price a buyer is offering to pay |
| best passive seller price | the "ask", "sell price" | the lowest price a sellers asks you to pay |
| spread | --- | the difference between bid and ask |
About buyers and sellers
| name | synonyms | definition |
|---|---|---|
| buyer/seller | means nothing, needs to be specified as active or passive (or obvious from context) | |
| the price | means nothing, needs to specify: which price? | |
| passive buyer | "book buyer (BB)" , "bidder", "buyer maker", | person that puts a buy order in the left-side of the order book, and is ok to wait for an active seller to sell |
| passive seller | "book seller (BS)" , "asker" , "seller maker", | person that puts a sell order in the right-side of the order book, and is ok to wait for an active buyer to buy |
| active buyer | "market buyer (MB)" , "buyer taker" | person that looks at the right-side of the order book to buy immediately |
| active seller | "market seller (MS)", "seller taker" | Person that looks at the left-side of the order book to sell immediately |