The limit order book is a critical component of the financial markets, particularly in the over-the-counter (OTC) market and the stock exchange. It is a record of trades that are potentially able to be executed between two parties at a specific price. This article aims to provide an overview of the limit order book, its functioning, and how it affects market efficiency and price formation.

What is a Limit Order?

A limit order is an order from a trader to buy or sell a particular amount of securities at a specific price or better. It is a type of order known as a "market order" or "stop order" in other financial markets. Limit orders are typically used by traders to specify their entry and exit points, allowing them to execute trades at a specific price and avoid market volatility.

Limit Order Book Functioning

The limit order book is a digital record of all limit orders placed by traders, organized by price and quantity. The book is divided into two sides: the buy side and the sell side. As prices rise, the buy side of the book moves higher, and the sell side moves lower. Similarly, as prices fall, the buy side moves lower, and the sell side moves higher.

When a trader places an order to buy or sell securities, it is added to the appropriate side of the limit order book. If the trade can be executed at the specified price, it is entered into the book and becomes a "match". If the trade cannot be executed at the specified price, it remains in the book as a "missing" trade.

The average price at which trades are executed in the limit order book is known as the "balance price" or "balance point". It is the price at which the buy and sell sides of the book are balanced, and trades are executed at this price. The balance point changes over time as new orders are placed and executed, and it affects the price formation in the market.

Effects of Limit Order Books on Market Efficiency

The limit order book plays a crucial role in maintaining market efficiency and price formation. It allows traders to place orders at specific prices, which can be executed by other traders at those prices. This mechanism ensures that trades are conducted at competitive prices, avoiding the effects of market manipulation and other forms of market abuse.

Limit order books also help to stabilize market prices, as they reflect the overall demand and supply for securities. As new orders are placed and executed, the balance price changes, reflecting the changes in supply and demand. This allows for a smooth flow of trades, maintaining price stability and preventing extreme price fluctuations.

Understanding the Limit Order Book in Practice

To better understand the limit order book, consider a simple example. Suppose a trader places a limit order to buy 100 shares of a particular stock at $50 per share. This order is added to the buy side of the limit order book, and the book is updated to reflect this new trade.

As the stock price rises, the buy side of the book moves higher, and the sell side moves lower. If the stock price rises to $51 per share, the trader who placed the initial limit order at $50 can no longer execute the trade at that price, as the balance price has moved to $51. Instead, the trader can execute the trade at the new balance price, which in this case is $51 per share.

The limit order book is a critical component of financial markets, allowing traders to specify their entry and exit points and facilitating trades at competitive prices. By understanding the functioning of the limit order book, traders can better navigate the market and make informed decisions. As market conditions change, the limit order book will adapt, ensuring a smooth flow of trades and maintaining price stability.