Limit Order Book: Definition, Structure, and Function

A Limit Order Book (LOB) is a real-time record of all outstanding limit orders in a financial market, representing buy and sell orders queued to be executed at specified prices or better. The LOB is a crucial component of modern electronic trading platforms.

Recording Buy and Sell Orders

The LOB consists of two primary segments:

• Bid Side: Contains all outstanding buy orders.
• Ask Side: Contains all outstanding sell orders.

Each order in the LOB is characterized by:

• Price Level: The specific price at which the order is to be executed.
• Order Quantity: The number of shares or contracts involved.
• Timestamp: The time at which the order was placed.

Aggregating Orders

Orders are typically aggregated at each price level, showing the cumulative quantity available. This helps traders understand the depth and liquidity at various price points.

Price Discovery

The LOB plays a pivotal role in the price discovery process by showcasing the supply and demand at different prices. It provides traders with insight into market sentiment and potential price movements.

Execution Mechanics

When a match is found between a bid and an ask price, a trade is executed. For example, if a buy limit order at $100 meets a sell limit order at $100, the transaction occurs, and both orders are removed from the book.

Example

Suppose the LOB for a stock XYZ looks like this:

This setup reveals that the highest bid is $99.00 for 500 shares and the lowest ask is $100.50 for 300 shares.

Market Orders vs. Limit Orders

• Market Orders: These are executed immediately at current market prices.
• Limit Orders: Executed only at specified prices or better.

Stop Orders

Stop orders become market orders once a specified price threshold is reached, differing from limit orders that remain pending until the price condition is met.

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