Order Types and Auction Markets Revisited

Last time I posted about how auction markets work and the idea of adding and removing liquidity.  In order to keep that post at a reasonable length I had to leave out a fair amount of information about how an auction market works.  Now I want to come back and re-visit those details.

First up, in the example I posted, there were only 3 participants – 2 adding liquidity and one removing it.  That might actually be the case in a very unpopular market, but in heavily traded markets there are 10s or even hundreds of active participants.  Here is a picture of the top levels of the order book for the ES futures market a few mornings ago:

This is a little complicated, so let me explain.  The ES contract is what’s called an “index future” – it’s a contract that mimics a stock index.  In this case, the index is the S&P 500 – which represents 500 of the largest US-traded companies.  The easiest way, for now, is to think that the value of the contract is the value of the index times $50 (there’s actually a little more complexity because it’s a future, but that doesn’t matter for this example).  So if the index value is 1100 then one contract would be $55,000 worth.  If you buy a contract of ES, you’re buying $55,000 of generic stock.

Now let’s go to the image.  The left side represents liquidity-adding buyers in the order book.  The right side represents liquidity adding sellers.  Notice that the prices step down on the left representing people willing to buy at lower and lower prices and they step up on the right side representing sellers at increasingly high prices.  Each line is prefixed with “GLOBEX” which is the Chicago Mercantile Exchange Group’s electronic exchange, and the only place where the ES contract is traded.  It’s an electronic auction market like I described last time.  The size column represents how many contracts are available at each price, and the cumulative size column represents the total amount of contracts available if you bought or sold everything from the current price to that point.

It’s worth noting that an auction market always has two current prices.  Any time there are both buy and sell orders at the same price, the matcher pairs them up and executes them.  As a result, the bids and offers/asks never overlap.  So there’s always a best bid price and a best offer/ask price, and they’re never the same.  The distance between them is referred to as the bid-offer gap.  The minimum gap is what’s referred to as “1 tick”.  A tick is the minimum price change that the exchange supports.  In the case of the ES contract, it’s 1/4 of an index point, which corresponds to $12.50 of contract value.  Note that the best bid is 1208.25 and the best offer is 1208.50 – 1 tick apart.

It’s also worth noting the shear amount of orders in the order book here.  The ES contract is one of the most liquid contracts in the world.  Suppose you wanted to buy huge quantities of US stock, and were willing to move the market slightly to do so.  If you moved the ES market 2 points from offer 1208.50 to offer 1210.50,  cumulatively you could buy 9439 ES contracts with each one worth $60,425 at the current offer price.  So in an instant you could buy $570 million dollars of stock – more than half a billion dollars – and only move the market price 0.16% .  That’s a HUGE amount.  When people are talking about liquidity, that’s what they’re talking about – the ability to enter large size orders and get them executed without moving the price an excessive amount.  In this case the order book actually extends above and below the prices shown in the picture, but my brokerage software doesn’t track those entries to keep data requirements down.

Also note that the shear number of contracts in the order book are there due to a very large number of participants in the market.  The ES contract has 5-10 major market making speculators (the trading desks of certain big banks and funds)  willing to trade hundreds of contracts either direction.  In addition, there are large numbers of smaller speculators that add to the liquidity in 1s or 10s of contracts.  Being an electronic market with anonymity, you can never be sure exactly which orders in the book belong to who.

Now that we’ve seen what the order book for a real market looks like, we can talk about order types.  Last article I introduced the limit order type.  But now we know enough to talk about other types as well:

  • Limit order – A limit order to buy buys anything in the book up to your limit price or the requested number of lots/contracts, whichever comes first.  The price you get will be the (potentially better) price in the book, not the price on the limit order.  Any remaining order after the limit price is hit is entered in the book for someone else to come fill.  A limit sell order does the opposite of a buy limit, selling down to your limit price and then putting any remnant into the book.  Thus limit orders can be liquidity adding or liquidity consuming (or some of both) depending on how the price matches what’s already in the order book.  Limit orders sitting in the book can be canceled by the trader at any time.
  • Market order – A market order does not have an associated price.   A market buy order simply buys whatever’s in the book, starting cheapest first.  If the book is exhausted, the rest of the order is canceled.  Note that this means a market order gives NO guarantee about what price it will execute at, although exchanges may have rules about how far from last price a market order can execute.  Market orders are always liquidity consuming.  In general market orders should be avoided, especially when entering positions, because of this lack of price guarantee.  Instead liquidity removing limit orders should be used.  Novice traders frequently make the mistake of using market orders when they shouldn’t, and sometimes get stuck with horrible prices as a result.
  • Stop order – a stop order is a triggered order, with the price of the order being a trigger price.  Once the stop price is hit, the order converts to a market order.  This is a little complicated, so an example might help.  Say current price is bid 102.50/ask 102.51.  If you enter the order BUY STOP 1 @ 102.60 then the order will be inactive until at least one trade executes at 102.60 or above.  If that happens, the order will convert to BUY MKT 1 and then immediately execute.  Note that the triggered price for a buy stop must be above the current market price, otherwise it just turns into a market order.  A sell stop is the opposite – it turns into a sell market order if price falls to the trigger price.  The most common use for stop orders is to cap the size of a loss – a so called “stop loss”.  If you own some security and set a sell stop at a lower price, you will exit your position when the stop price is hit.  This can serve as an emergency exit of sorts that will trigger even if you are not paying attention to the market.  Stop orders are retained in the order book until triggered somewhat like limit orders, but they are hidden from other market participants.  There’s a lot to be said about stop orders, and their uses and problems – I’ll tackle that in a future post.
When a market has a large number of participants like the ES market does, there are frequently multiple people with limit orders in the book at the same price.  This raises a question: when a marketable order comes in and fills some of the orders in the book at that price, who gets filled first?  The answer depends on the market, but for most major markets the order that went in the book first gets filled first.  This is commonly abreviated FIFO for “first in, first out”.  Similarly, when there are multiple stop orders at the same price, the first ones entered are triggered first and may get better prices for the resulting market orders.I realize this may seem like a painful amount of detail about how markets work, especially if you’re just getting started.  But a lot of trading strategies, especially shorter term ones, are heavily dependent on the specifics of how auction markets work.  You can gain an edge on other traders by having a full understanding of the mechanics of how a market actually works and then applying that information in your trading strategies.

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