In the crypto market, most crypto traders and investors buy and sell cryptocurrencies on a centralized exchange (CEX).
A key concept that you should understand before placing your first crypto trade on an exchange is the “order book”.
An order book offers a real-time “behind the scenes” view into the supply and demand of a particular cryptocurrency.
In this lesson, I will discuss the purpose of a crypto exchange’s order book and how it is used to execute trades.
What is an order book?
An order book is a list of all the pending (or “open”) buy and sell orders that are currently available for a specific trading pair.
The order book is public, allowing all users on an exchange to see the orders in the market.
As traders add, remove, change, and execute orders, the order book will change.
For example, a crypto exchange could have an order book for the BTC/USD trading pair.
The order book will have all the buy and sell limit orders that customers have placed on the exchange to either buy or sell bitcoin (BTC) for U.S. dollars (USD).
Since the price of bitcoin (BTC) is using USD as the quote currency, this means that BTC is priced in USD on the order book.Crypto exchanges all you to trade multiple trading pairs. For example, aside from being to trade BTC/USD, you can also trade other cryptos/fiat pairs like ETH/USD, BNB/USD, ADA/USD, or even crypto/crypto pairs like ETH/BTC or ADA/ETH.
Each trading pair has its own order book. So on a crypto exchange, there is not just one order book, but many!
Anybody can place a pending order, also known as a “limit order” on an order book.
That order will remain on the order book until the person that placed the order either:
- Cancels the order or…
- Another person agrees to take the order.
For example, if you place a limit order to buy bitcoin (BTC) for 30,000 USD, someone else on the exchange will need to agree to sell bitcoin BTC) at the same price of 30,000 USD.
Placing an order does not necessarily mean that another person will agree to take your order. If someone else on the exchange places a better order than the one you placed, then that order will be taken first.
Returning to the previous example, if someone else places a limit order to buy bitcoin (BTC) for 30,001 USD, which is higher than your order price of 30,000 USD, then that order will be taken first. Why would a seller accept your price when it can get a slightly higher price instead?
The requirement to take the best available bid or ask price is enforced by a crypto exchange so its customers don’t accidentally take a worse price than the best one available.
How do I use an order book?
When you place an order on the exchange, you have two options.
- You can place a limit order that will “sit” in the order book and wait for someone else to take it.
- You can immediately take someone else’s limit order that’s already “sitting” on the order book.
Here’s an example of what an order book looks like:
The asks are shown in red and the bids are shown in green.
For each price level, you will see a “Market Size” or “Cumulative Quantity”. This is the quantity of the cryptocurrency that are willing to be bought or sold at that specific price.
You can think of the order book as representing supply and demand.
The asks are people offering their bitcoins (BTC) for sale on the exchange and providing supply to fulfill the demand from buyers.
This order book shows the available buy and sell orders for the BTC/USD trading pair.
- The buy side (in green) represents all open buy orders (“bids”) below the last traded price.
- The sell side (in red ) represents all open sell orders (“asks”) above the last traded price.
If you look closely, near the middle, you can see the “best bid” and the “best ask”.
The “best bid” price, which is the highest price someone is willing to buy some bitcoin, is 29968.79
The buyer(s) who entered this order is basically saying, “Yo, I am bidding on 0.0474 units of BTC in exchange for 29968.79 USD.”
The “best ask” price, which is the lowest price someone is willing to sell their bitcoin, is 29969.62
The seller(s) who entered this order is basically saying, “Yo, I am asking someone to buy 0.0276 units of BTC that I own for 29.969.62 USD.”
The gap between the highest buying price (“best bid”) and the lowest selling price (“best ask”) is called the “spread“.
The spread measures the difference between the highest buy order and the lowest sell order.
In this case, the spread is 0.81 USD.
What if I want to buy?
If you want to buy BTC/USD, you can either:
- Place a buy limit order on the buy side (green text)
- Take the best ask on the sell side (red text)
Since the best ask price on the sell side is 29.969.62 USD, you can instantly “take” that price by placing a “market order“.And you become the proud new owner of 0.0276 bitcoin. 😁
Otherwise, you would need to place (or “ make”) a buy “limit order” specifying a “limit price” that is less than or equal to 29968.79 USD on the buy side.All these buy limit orders remain “open” and will just “sit” in the order book until someone agrees to sell or “take” at the limit price.
There is no guarantee someone else will ever agree to sell at the available “limit prices” or “bids” so you don’t know how long your order will “sit” before it’s ever taken.
For example, if you place a buy limit order for BTC?USD with a limit price of 1 USD, you might die of old age before you ever find someone willing to sell you bitcoin at that price…unless the crypto market experiences the greatest crash ever. 😱
Assuming that doesn’t happen, your “bid” will just “rest” or “sit” in the order book until you manually cancel the order.
What if I want to sell?
If you already own some bitcoins and want to sell BTC/USD, you can either:
- Place a sell limit order on the sell side (red text)
- Take the best bid on the buy side (green text)
Since the best bid price on the sell side is 29968.79 USD, you can instantly “take” that price by placing a “market order“.And say goodbye to 0.0474 of your bitcoin. 👋
Otherwise, you would need to place (or “ make”) a sell “limit order” specifying a “limit price” that is more than or equal to 29.969.62 USD on the sell side.Typically, a crypto exchange will charge a higher fee if you “take” an order versus if you “make” or place a limit order for others to “take”.
This fee model used by crypto exchanges is known as the “maker-taker” fee model and will be discussed in more detail in the next lesson.