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How to read an order book

If you want to adopt an active trading style, you need to know how to read the market. Knowing how to read the order book is an essential skill that will help you understand more about an asset’s buy and sell pressure.

The order book provides you with the insights you need to make an informed decision and placing an order with a fair chance of making a profit. The data available from the order book gives you an “under-the-hood” look at a market’s structure and dynamics. Let’s start with the basics of order book components.

Order book basics

Practically every exchange in the world, trading crypto or other assets, will have an order book for each of the markets available on the exchange. The order book is simply a list of pending buy and sell orders that traders are placing at an exchange for a specific asset. In other words, the order book records the interest of buyers and sellers in a particular asset.

The buy and sell orders are displayed on separate sides. Each recorded order will show the total amount and price. If you’re placing a buy order for 0.3 BTC at $9500, the information recorded in the order book shows the price at the full unit (1 Bitcoin at $9500), together with the total amount of crypto in demand (0.3 Bitcoin).

Matchmaking  

When you observe an order book for a couple of seconds, you’ll see the book is dynamic with numbers constantly moving and updating in real-time. When you see the numbers changing, it means that the buy and sell orders are either cancelled by the traders or they are filled through a process called matchmaking.

Matchmaking is a process that seeks to match buy and sell orders. When your buy order for 0.3 BTC at $9500 is met by a sell order at the same price, the match is made and the order is filled. If the sell order was only for 0.1BTC, the order is partially filled and the remaining 0.2BTC at $9500 remains outstanding as a partial open order, for which another sell order needs to be found. On a solid crypto exchange with liquid markets, this all takes place in milliseconds.

The first orders placed are the first orders matched. When orders are matched, they are taken off the order book and the market continues to fill the next buy and sell orders in line.

Interpreting the spread, market depth and liquidity

The difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept is called the bid-ask spread, or simply the spread. This number is usually displayed above the order book and updated dynamically as orders are cancelled or filled.

The spread serves as an indication for the supply and demand of an asset: when the spread widens, it indicates there is a change in the supply and demand for a crypto asset as market makers adjust their bids.

The bid-ask spread relates to a market’s overall liquidity from the interaction between market makers and price takers, and the market depth of an order book i.e. the number of bids and asks on an order book across various price levels. If many bid and ask orders are placed at deep price levels without affecting the price of an asset too much, it indicates the market is liquid because the order book is able to absorb larger market orders. Basically, the tighter the spread, the more liquid the market.

Conversely, when market depth is weak, large buy or sell orders push the price of an asset down or up by eating through the order book, disrupting market maker’s positions. To account for that risk, bid-ask spreads tend to widen. By reading the spread you can interpret the amount of risk market makers perceive in relation to depth and liquidity of the market. In markets with low liquidity, it is more difficult to exchange assets at stable prices.

The same widened spread can also indicate the risk perceived in relation to volatility, as market makers tend to hedge their positions to protect themselves against price swings.

Finally, looking through the window of market depth, you can at times detect levels or support or resistance at deeper price levels. It usually indicates market sentiment held by a large number of crypto traders, but sometimes it’s the work of a crypto whale lurking in the deep.

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