Derivatives and advanced market conceptsModule 5, lesson 19 of 21
Market microstructure
Order book depth, price-time priority, market impact, hidden liquidity and market makers, and why execution costs grow with order size.
In this lesson
- Read an order book showing bids, asks and depth at each price.
- Explain price-time priority and how orders are matched.
- Calculate the average price and impact cost of a market order that walks the book.
- Explain the roles of market makers and hidden liquidity, and why larger orders cost more to execute.
Builds on
- Liquidity and slippage in derivativesThis lesson looks in detail at the liquidity and slippage introduced there.
- Market orders and limit ordersMicrostructure builds on how market and limit orders work.
On this page
In simple terms
Market microstructure is the study of how trading actually happens: how orders wait, meet and move prices. It explains why the price on the screen is not always the price you get, and why trading costs depend on how much you trade and when.
The order book
An exchange keeps an order book for each instrument: all the limit orders waiting to be filled, as the market and limit orders lesson explains.
Worked example: A made-up order book
| Bid quantity | Bid price | Ask price | Ask quantity |
|---|---|---|---|
| 600 | ₹99.90 | ₹100.00 | 500 |
| 900 | ₹99.80 | ₹100.10 | 800 |
| 1,200 | ₹99.70 | ₹100.20 | 700 |
| 2,000 | ₹99.50 | ₹100.50 | 1,000 |
The best bid is ₹99.90 and the best ask ₹100.00. The spread is ₹0.10, and the mid-price is ₹99.95. The quantities at each level are the depth.
Price-time priority
Exchanges match orders by price first, then time. A buy order at a higher price is filled before one at a lower price; at the same price, the earlier order goes first. Joining the back of a long queue at the best price can mean waiting a long time, or never being filled.
Walking the book
A market order takes whatever is available, starting at the best price.
Worked example: Buying 2,000 shares at market in the book above
| 500 shares at ₹100.00 | ₹50,000 |
|---|---|
| 800 shares at ₹100.10 | ₹80,080 |
| 700 shares at ₹100.20 | ₹70,140 |
| Total for 2,000 shares | ₹2,00,220 |
| Average price: 2,00,220 ÷ 2,000 | ₹100.11 |
| Compared with the mid-price of ₹99.95 | about 0.16% higher |
The order pushed through three price levels. The difference between the average price and the mid-price is the impact cost.
Impact cost rises with order size and falls with depth. In thin markets, such as far option strikes, a modest order can move the price a long way, as the liquidity lesson explains.
Market makers and hidden liquidity
- Market makers continuously quote both bids and asks, earning the spread in return for providing liquidity and taking on inventory risk. In many markets, they are firms using automated systems.
- Hidden liquidity: some orders show only part of their size, so the visible book understates what is available, or overstates it if orders are cancelled.
- Fast-changing quotes: algorithms add and cancel orders in fractions of a second. Depth visible now may not be there when your order arrives, as the algorithmic trading lesson explains.
Execution in practice
- Limit orders control price but may not fill.
- Market orders fill but at uncertain prices.
- Splitting large orders over time reduces impact but risks prices moving meanwhile.
- Trading at busy times, when depth is greater, usually costs less than at quiet times.
Costs you cannot see on a chart
A price chart shows trades that happened, not what it would have cost to trade a particular size at that moment. Two traders following the same signals can get very different results if one trades small, liquid positions and the other large or thin ones. Strategies that look profitable on charts often lose their edge once spreads and impact are included, as the backtesting lesson warns.
Why it matters
Execution costs are invisible on a price chart but real in every trade. For frequent traders and for anyone trading thin instruments, they can be larger than brokerage. Understanding the order book shows why the screen price is not your price, and why size and timing matter.
Limitations
The example is a simplified snapshot. Real order books change continuously, and exchanges offer various order types and protections with rules that change over time. Hidden and cancelled orders make depth harder to judge.
Common mistakes
- Assuming any quantity can trade at the screen price.
- Using market orders in thin markets.
- Ignoring impact cost when comparing strategies.
- Trusting visible depth to stay in place.
Try it yourself
- Using the made-up book, calculate the average price of selling 2,000 shares at market.
- Calculate the impact cost compared with the mid-price.
- Look at the market depth display for a share on a broker platform during busy and quiet times, and compare the spreads and quantities.
Key takeaways
- The order book lists waiting buy orders (bids) and sell orders (asks) at each price, with the quantity at each level, called depth.
- Exchanges match orders by price first, then by time. Better prices go first; at the same price, earlier orders go first.
- A large market order can use up the quantity at the best price and move to worse prices, walking the book. The extra cost is market impact.
- Some quantity is hidden, and market makers and algorithms constantly add and withdraw orders, so visible depth can change in a moment.
- Execution costs rise with order size and fall with liquidity. The price on the screen is not the price for any quantity.
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Terms used in this lesson
- Order book
- The live list of all waiting buy and sell orders for a share, with their prices and quantities.
- Impact cost
- The extra cost of a trade caused by the order itself moving the price, measured against the mid-price before the trade.
- Market maker
- A trader or firm that continuously quotes both buying and selling prices, earning the spread for providing liquidity.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.