This week I have been learning about limit orders and limit order books. Using a limit order allows traders to set a maximum buying price and a minimum selling price for a trade. They can be beneficial when buying stock but may be detrimental when selling stock. Traders usually place a limit order under the current price of a stock when buying and over the current price of the stock when selling.
Example (from dummies.com):
“Maybe you want to buy Kowalski, Inc., but the current market price of $20 per share isn’t acceptable to you. What do you do? You tell your broker, “Buy Kowalski with a limit order at $16” (or you can enter a limit order at the broker’s website). You have to specify whether it’s a day order or a GTC order.
What happens if the stock experiences great volatility? What if it drops to $16.01 and then suddenly drops to $15.95 on the next move? Nothing happens, actually, which you may be dismayed to hear. Because your order was limited to $16, it can be transacted only at $16 — no more and no less.
The only way for this particular trade to occur is if the stock rises back to $16. However, if the price keeps dropping, then your limit order isn’t transacted and may expire or be canceled.”
A limit order book is a record for unexecuted limit orders maintained by a specialist that works at the exchange. The specialist keeps a record of all the orders and executes them if the pricing and inventory are available.
Investopedia provides a good explanation about the upkeep of limit order books:
“The specialist running the limit order book has the responsibility to guarantee that the top priority order is executed before other orders in the book, and before other orders at an equal or worse price held or submitted by other traders on the floor (floor brokers, market makers, etc.). In 2000, the Securities and Exchange Commission (SEC) began to create a centralized limit order book that keeps track of limit orders on exchanges electronically. This electronic order tracking system automatically matches for execution the best possible pair of orders in the system. The best pair is made up of the highest bid and the lowest ask orders. The bid is the price the specialist/exchange will sell a security or the price at which an investor can buy the security. The ask/offer is the price
at which the specialist/exchange will buy a security, or the price at which the investor can sell the security.”
Over the next week, I will be finding as much information as I can about limit orders on Bitcoin and Ethereum and keep you guys posted.