If you want to become an expert crypto trader and make excellent trades with little to no losses, then you’ve got to know how an order book works.

Seeing an order book for the first time can be pretty intimidating, no doubt. There are several moving parts and all those blinking lights and whatnot.

The good thing, however, is that once it’s understood, it makes all the sense in the world and becomes an indispensable tool for profitable trades. Read on as we explain the basic concepts surrounding the operation of an order book and its importance in the crypto space.

What Is an Order Book?

An Order Book is a list of open or outstanding orders for a particular trading pair. Consequently, each trading pair on an exchange has its order book, which means exchanges usually have several order books.

Order books are publicly accessible, so everyone on an exchange has access to all the order books at any time. Keep in mind that order books will look different across exchanges.

Nevertheless, all order books typically contain the same information and share four fundamental components. Once you understand these components, reading order books will become easy, regardless of what exchange they’re on. Make sure to keep reading because we’ll get to that in a bit. In the meantime, let’s learn how an order book works.

How Does an Order Book Work?

Source: Gate.io Exchange

Order books are dynamic ledgers. In other words, the ledger is constantly changing. This is because limit orders are being created, completed, and canceled all the time. And as each of these activities take place on an exchange, the information on the order book will change.

Now, every order book has a matching engine. A matching engine refers to a system that helps to execute trades on behalf of users of an exchange. In simpler terms, matching engines match buy orders with sell orders. Here’s how that works.

The first thing you need to know is that placing a limit order on an exchange does not necessarily mean that your order will be accepted automatically. By the way, a limit order is a price at which you’re willing to sell or buy an asset.

For instance, say you want to buy some bitcoin, and the best you’re willing to pay is $16,000. So, you set a limit order on your preferred exchange to buy bitcoin at $16,000, and the order book takes note of it under the buy section.

Meanwhile, other people are also placing limit orders to sell their bitcoin, which you’ll find under the sell section of the order book.

After placing your order, the match engine gets to work, trying to find a seller that’s willing to sell at your price. If the engine finds one, it matches both of you. But if a buyer is offering a better price, then the matching engine will take their order before yours, and yours will remain open till a seller is willing to sell at your price.

Crypto exchanges set this, as a rule, to make sure that their users are always getting the best trades at any time.

What Type of Crypto Exchanges Use Order Books?

Speaking of crypto exchanges, order books are typically used by centralized exchanges (CEXes) to facilitate trades like with the traditional stock market. However, the invention of blockchain technology has revolutionized things, making it possible to match buy and sell orders algorithmically using a tool called Smart Contracts and Automated Market Makers (AMM).

Exchanges that use smart contracts instead of order books are known as decentralized exchanges (DEXes). Many crypto puritans believe that decentralized exchanges and the use of smart contracts are better ways to trade crypto assets than order books in CEXes. The argument usually is that only DEXes provide the real benefits of crypto trading, especially anonymity.

However, it is pertinent to note that CEXes with their order books are far simpler for beginners to use than smart contracts in DEXes. Also, CEXes can be less expensive to use than DEXes.

How to Read an Order Book?

Source: Gate.io Trading App

As earlier stated, order books vary from exchange to exchange. But once you get the hang of four fundamental concepts, you’ll be able to read any order book, regardless of what exchange it’s on.

The four main concepts are amount, price, buy side, and sell side. Let’s explain them:

Price and Amount

We will explain these two together because they are quite similar, and you can find both items on the buy side and the sell side of the order book.

Amount and price tell you the total quantity of crypto available to be traded and the price at which each unit is valued.

For instance, say you’re on the buy side of the order book, and you see a value of “2.50” under the amount column and then a value of “8,219.70” under the price column. What this means is that whoever placed the order would like to buy 2.5 units of bitcoin and is willing to pay $8219.70 for each unit. It’s that simple! Now, let’s take a look at the buy side and the sell side.

The Buy Side

It is easy to locate the buy side of an order book because it is usually in green. Bids are located on the buy side of the order book, which is a list of all pending buy orders. You want to keep in mind that the open orders you find on the buy side will all be orders below the last traded price. Any offer from a buyer is known as a “bid.” You definitely recognize that from everyday lingo.

When a buyer wants to voice their interest in a particular item, they usually say they are bidding for that item. It is the same with crypto. When a buyer places a bid, essentially, they are saying, “I am interested in xyz number of units of crypto you have. I hope to buy them at this price.”

Sometimes, a particular price level sees a huge amount of buy orders and it forms something we call a “buy wall.”

Why are Buy Walls Important?

If the orders at any particular price become too large to be filled, then buy orders with lower bids will not be filled either. But that’s a good thing in a way because it means that the price of that asset can’t dip below that price level. In other words, the price of the asset is now at a short-term support level, an indication that the price might temporarily go up soon.

The Sell Side

Asks are the opposite of bids and are recorded on the sell side of the order book. Asks represent all open sell orders, in other words, the seller is saying, “I am asking if anyone would buy xyz number of units of this crypto I own at this price.”

Keep in mind that the sell side of the order book will list all asks above the last traded price. Like with buy orders, an abundance of sell orders at a particular price could also form a wall, known as a sell wall.

If there is a huge sell order that can not be filled because demand is too low, then sell orders with lower asks will not be executed. When this happens, the price level of the asset in question meets a short-term resistance, which means that prices could temporarily dip.

How to Use an Order Book to Trade

Let’s say you are looking to buy some bitcoin using USD, you can do that one of two ways. You could place a buy-limit order or you could just take the best ask on the order book by placing what is called a market order. The second option is much faster, as you might be able to tell, whereas the first option, that is, placing a buy limit order, could take an indefinite amount of time.

As we have already seen, any buy order will remain on the order book until there’s a sell order that matches that bid or the buyer gives up and cancels the order altogether.

Now, for selling, there are two ways to do this. You can place a sell limit order or you can just take the best bid you find on the buy side by placing a market order. As usual, setting a limit order could take a while.

Why Are Order Books Important?

Order books give a trader in-depth insight into the market which enables better trades. Here is a quick rundown of some insights you can gain from an order book.

• If there are more buyers than sellers, then a price uptrend might be around the corner, and vice versa.
• Using the order book, you can decide to enter the market as a market maker. Market makers are entities that match buying and selling orders at prices that no one else would accept. It might seem like a bad deal but then you get to enjoy the benefit of lower fees from the exchange.
• In addition, order books provide information about market depth, and market depth tells you about the liquidity of a particular market. The more liquid a market is, the less volatile the price of that asset and the faster and easier it is to buy or sell the asset.

On the other hand, if the market is not liquid, then whales can easily manipulate the market using the order book. For instance, if a whale wants to dump their holding at a higher price, they could post a large buy order at a price higher than what you find on the order book.

This will trick buyers into thinking that the whales believe that there is a price uptrend around the corner. And if traders think that, they will begin to buy more assets which will inevitably raise the price of that asset like a self-fulfilling prophecy.

Once the price is high enough, the whales can now sell off their holdings and make a huge profit. Ultimately, this will crash the price of the asset and leave small traders in the dumps.

Conclusion

Do not get frustrated if you do not seem to get the hang of using order books immediately. As always, practice makes perfect. So, the key to being adept at interpreting and using order books is patience and practice. Once you get the hang of it, you will find that it’s an invaluable tool for your crypto trading venture.