In this article we will see a powerful tool to reduce the risk of selling and buying at unfavourable prices: the order book analysis. We will see what is the order book and how it works.
The order book is a database in which orders entered but not yet executed are stored. If, for example, John enters a limit order to sell BTC at $7500, Marco enters a limit order to buy BTC at $6500, and the price remains around $7000, the two orders won’t be immediately filled. In that case, they’ll remain in the book until the price moves, and someone sells BTC at $6500 or buys it at $7500.
How the order book works
To better understand this concept, let’s see an example of an order book taken from the website Bitfinex. You can find the order book in the lower part of the BTCUSD page if you want a live example. Both on the side of purchases (green) and on the one of sales (red), we can see four columns:
Price – the reference price for a single row. In this case it is an interval – for example, $6860 refers to orders between $6860 and $6869,99;
Count – the number of orders at a given range;
Amount – the quantity sold in the order (if, for example, we were operating on the pair ETH/BTC, we’d see this number in ETHs);
Total – the total of sell orders in the range between the current price and the price at a given level in the book.
The zoom of the book can be adjusted on different ranges; in this case, we decided to zoom the price in the $10 range, to better analyze the market situation at present. Rows shows us some price intervals. For example, $6870 in the column “price”, tells us that between the market price and the price of $6870, there are purchase orders for 86.2 Bitcoins. Between $6860 and $6850 (column below), there are other 72.5 bitcoins of purchase orders and so on.
What happens in the book is that traders often tend to create “walls” (“walls”) of orders by concentrating buy orders (“buy wall”) or sell orders (“sell wall”). In practice, there can be price levels with many buy/sell orders that are just “walls” that must be broken down to allow the market to go further. In the example above, if you entered a purchase order of 100BTC at $6870, you create a “wall” of purchases, so, you’d need to sell a total of 100 more bitcoins to “tear it down” and allow the price to fall below $6870. This is extremely important information: the more buy/sell orders are placed on a given price range, the more difficult it’s for the market price to go beyond that.
The overview of the buy-sell balance in the order book can be used in two ways: (1) analyzing the price trend in the very short term and (2) minimizing transaction costs. The second way is the most useful but in order to understand it, we must first go through point 1:
1) Using the order book to analyze the price
Let’s go back to the previous screen. What do we see in that graph? On the side of the sales orders (green), there are many purchase orders at around $6850. It’s easy for the price to reach that level, but it’s difficult for it to fall below: So, it’s a level to be monitored in case of a price fall. We also see that there are more purchase orders (green) than sale orders (red): it could be a sign of an excess demand that could lead the market to rise again. In these cases, you must be very careful, because sometimes some “big players” take advantage of these dynamics to enter large orders (which are then not executed) and mislead other investors.
Remember: in the crypto market, there are many exchanges, so it’s appropriate to follow only the books of the largest ones, where the real “price discovery” takes place.
However, it’s clear that the imbalances in the order book are crucial to have a further suggestion on possible price trends, particullary short-term trends. Anyway, the margins are so small that it’s hardly useful information, but it remains a factor to consider in some “delicate” moments in which the price is close to significant psychological barriers (for example, $6000 or $7000).
2) Less costs for buying and selling
The analysis of the order book can also be used to minimize “transaction costs” – i.e., one of the biggest difficulties in obtaining profits from trading and investing in general (although they have a greater impact for shorter term activity such as trading). Transaction costs are % of “extra” costs that we incur when we buy and sell – commissions plus possible cost related to market liquidity.
In particular, the order book allows us to evaluate the costs related to liquidity: let’s assume that the last traded price of Bitcoin (or “market price”) is $ 6900, but there are purchase orders at $6890 and sale orders at $6910. If I want to buy, I can’t buy for less than $6910; if I want to sell, I have to settle for $6890: in both cases, I lose 0.1% because the liquidity in the market is low and there are not enough buyers and sellers to get an advantageous price available: otherwise, if, for example, someone placed a purchase order at $6890 someone else could try to overcome it by placing a purchase order at $6891 (so as to have priority), and so on the demand side too, until buyers and sellers would both be close to $6900, and we can buy/sell at the market price.
The concept of transaction costs may seems very abstract, but these costs represent a huge challenge: many seemingly winning trading strategies collapse if realistic transaction costs are computed too. Reducing them is essential.
Let’s take a more practical example by looking at the BTC/USD exchange book on Bitfinex on the afternoon of April 21, 2020. We zoomed in at 1 dollar intervals, and we considered only the levels closest to the market price. As you can see, there are very few purchase orders between $6901 and $6899.
If I plan to buy Bitcoin, I could place a purchase order at $6899, because the price is likely to hit that level in the next few seconds or minutes. This way, I can buy at slightly lower prices and obtain better conditions. There can be a risk that the market will move in the opposite direction, and, plus, some of the sell orders may be created to mislead other traders about the market trend, but placing orders this way is always a good strategy.
2.1) Market maker and taker: how to pay less
Furthermore, very often, exchanges charge those who place orders on the book less commissions, by adopting tariff structures called Makers and Takers. Imagine that Bob placed a purchase order for 1 BTC for $ 6900 and Alice sells 1 BTC for $ 6900. Makers are those who enter “limit orders” into the market by filling the order book, this is good for the Exchange as they contribute to the liquidity of the Exchange and therefore pay less. In our example, BOB is a maker. Vice versa, the Takers (Alice), are those subjects that contribute to “close” the orders placed by the Makers, these people pay higher commissions.
In short, analyzing the order book, you can do like Bob and try to buy/sell at best, and, in some cases, pay fewer commissions. There’s still the risk that the price moves and, for example, goes up to $6910 leaving Bob empty-handed, and, in fact, you have to be cautious; but a careful usage of the order book can lead to more advantageous buying and selling conditions: a considerable advantage.
The subject is quite complex, so don’t hesitate to ask: did you find this article useful? Are there any points on which you would need clarification? Ask in the comments, and we will try to answer you as soon as possible.
Good luck with the market and keep an eye on the Book!