Strategic Economics

The Limit Order Book and Where a Price Comes From

A price is not a fact about an asset. It is the top of two sorted queues of unexecuted intentions, and everything you pay above or below it comes from how those queues are arranged. Learn to read the arrangement and the cost of a trade stops being a surprise.

  • Advanced
  • 14 min total
  • 13 chapters

What decision this helps you make: How to send an order into a market — what size, what order type, and at what price — once you can see that the quoted price applies to a specific and usually small number of shares, and that everything beyond that is a different price.

What this topic is

A limit order book is a list. On one side sit every unexecuted offer to buy, sorted from the highest price down; on the other, every unexecuted offer to sell, sorted from the lowest price up. Each entry carries a price and a quantity. The highest price anyone has publicly committed to buy at is the bid; the lowest anyone will sell at is the offer, or ask. Nothing about the asset determines those two numbers — they are simply the front of two queues of people who have written down what they will do and have not yet had to do it. A trade happens when someone accepts the front of a queue, and the "price" of the asset is the record of that acceptance.

Why it matters

Almost every published price you have ever quoted in a meeting is either the last trade or the midpoint between the two queues, and neither one is a price you can transact at in size. The quote applies to the specific quantity displayed at it, which in a mid-cap stock can be a few hundred shares. The moment your order exceeds it you are buying from the next level, and the next, at prices that get worse in a way you can compute in advance from the book itself. Learning to read a book converts execution from something that happens to you into a number you estimate before you send anything.

Who should learn it

Anyone who has to sell or buy a position larger than a screen quote, founders and CFOs facing a secondary or a buyback, operators designing any auction or matching mechanism, and readers who want to understand what the word "price" actually refers to in a modern market.

What you will understand

  • What a limit order book contains, how price-time priority orders it, and what happens mechanically when an order arrives
  • How to compute the real cost of an order by walking it through visible depth, and why effective spread exceeds quoted spread
  • Why posting a limit order is writing an option to the rest of the market, and what you are paid for it
  • Which parts of a book are informative — imbalance, depth, the microprice — and which parts are cancellable noise

Prerequisites

Common misconception

"The price of the stock is $42." There is no such number. There is a highest standing bid, a lowest standing offer, a gap between them, and a last trade that happened in the past at a size you did not choose. In the book worked through in this lesson, the two queues sit at $41.98 and $42.02, the midpoint is $42.00, and nobody at all can transact at $42.00. A 3,000-share buy pays an average of $42.03 and a 12,000-share buy pays $42.04 — from the same book, in the same second, with no news and no change in anyone's opinion about the company. The price was never a property of the asset. It was a property of the queue.