Learn to read the order book — Stock-Market notes

WHAT is the order book?

Key derived quantities (we build these from first principles below):

Best Bid = highest price someone will pay.
Best Ask = lowest price someone will sell for.
Spread = Best Ask − Best Bid.
Mid price = the average of best bid and best ask.

WHY does the book look like two stacks?

Deriving the core numbers from scratch

Let the best bid price be $b$ and best ask price be $a$ , with $a > b$ (else a trade happens).

Spread. The spread is simply the cost of "crossing" from one side to the other: $S = a - b$ Why? If you want to buy right now you must pay the ask $a$ ; if you immediately sold you'd only get the bid $b$ . The instant round-trip loss is $a-b$ . That loss is the spread.

Mid price. The fairest single "price" of the asset lies exactly between the two best intentions: $M = \frac{a+b}{2}$ Why the average? With no other info, the true value is equally likely to be anywhere in $[b,a]$ ; the expected value of a uniform guess is its midpoint.

Weighted mid (micro-price). The naive mid ignores how much size is on each side. If there's huge bid size $Q_b$ and tiny ask size $Q_a$ , buyers dominate → fair value leans toward the ask. Weighting by the opposite side's size: $M_w = \frac{a\,Q_b + b\,Q_a}{Q_b + Q_a}$ Why opposite side? Large bid volume ( $Q_b$ ) is demand pressure pushing price up toward $a$ , so it gets multiplied onto $a$ . This is a first-principles measure of imbalance.

Order-book imbalance (OBI). A pure pressure ratio in $[-1, 1]$ : $\text{OBI} = \frac{Q_b - Q_a}{Q_b + Q_a}$ $\text{OBI} > 0$ → more buyers → upward pressure. $\text{OBI} < 0$ → more sellers → downward pressure. Why divide by the total? To normalize: an imbalance of 100 lots means little on a huge book but everything on a thin one.

HOW to actually read it (worked examples)

Worked example Example 1 — Spread, mid, and cost to cross

Book:

Bids (px × size)	Asks (px × size)
100.20 × 800	100.25 × 500
100.15 × 1200	100.30 × 900

Best bid $b=100.20$ , best ask $a=100.25$ .

Spread $S = 100.25 - 100.20 = 0.05$ . Why this step? It's the price gap between the two best resting orders — the immediate round-trip cost.
Mid $M = (100.20+100.25)/2 = 100.225$ . Why? Midpoint = fairest single price with no size info.
If I market-buy 500 shares I pay 100.25 (all of best ask); I want 900, I take 500@100.25 + 400@100.30. Why? Market orders walk the book, eating each level top-down until filled.

Common mistakes (steel-manned)

Recall Feynman: explain to a 12-year-old

Imagine a market stall. On the left, kids shout how many candies they'll buy and the highest price they'll pay — the loudest (highest price) kid stands at the front. On the right, kids shout how many candies they'll sell and the lowest price they'll accept — the cheapest seller stands at the front. The front buyer and front seller stare at each other with a tiny gap between their prices; that gap is the "spread." Whenever a front buyer agrees to the front seller's price, candy changes hands and they both leave. If way more kids want to buy than sell, the price is about to go up. That whole shouting board is the order book!

Flashcards

What are the two sides of an order book?

The bid side (buyers, sorted highest price on top) and the ask/offer side (sellers, sorted lowest price on top).

Define the best bid.

The highest price any buyer is currently willing to pay.

Define the best ask.

The lowest price any seller is currently willing to accept.

Formula for the spread?

S = a - b

(best ask minus best bid); the immediate round-trip cost.

Formula for the mid price?

M = (a+b)/2

, the midpoint of best bid and best ask.

Why can the best bid never exceed the best ask in a resting book?

If it did, a trade would fire instantly and remove those orders — leaving best bid strictly below best ask.

Formula for order-book imbalance (OBI)?

(Q_b - Q_a)/(Q_b + Q_a)

; ranges

[-1,1]

, positive = buy pressure.

Why weight the micro-price by the opposite side's size?

Large bid volume is demand pushing price toward the ask, so bid size multiplies onto the ask price and vice versa.

Can you buy at the mid price?

No — you buy at the ask, sell at the bid; the mid is only a reference.

What is spoofing?

Posting large orders (usually away from top) with no intent to trade, cancelling before execution, to bait other traders.

What does a market order do to the book?

It walks the book top-down, consuming each price level until the full size is filled (causing slippage).

Why isn't level-1 depth enough to read?

Because depth behind the top (levels 2-5+) determines how far price slips on large orders.

Connections

Order Flow & Tape Reading — the book is displayed intent; the tape is executed fact.
Bid-Ask Spread — the spread derived here is the core transaction-cost measure.
Market Microstructure — order-book dynamics are its foundation.
Limit Orders vs Market Orders — limit orders build the book, market orders consume it.
Liquidity & Depth — cumulative size across levels.
Spoofing & Layering — manipulation patterns visible in the book.
Slippage — direct consequence of walking multiple book levels.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Order book samajhna basically ek live auction board padhna hai. Left side pe bids hote hain — matlab jo log kharidna chahte hain, apna price aur quantity dikhate hain. Right side pe asks (offers) — jo bechna chahte hain. Rule simple hai: sabse zyada paying wala buyer sabse upar (best bid), aur sabse sasta bechne wala seller sabse upar (best ask). In dono ke beech ka gap hi spread hai — jitna chhota spread, utni acchi liquidity.

Mid price = (best bid + best ask) / 2, ye sirf ek reference hai; yaad rakho tum mid pe trade nahi kar sakte — kharidoge to ask pe, bechoge to bid pe. Jab tum ek bada market order maarte ho, wo book ko upar se neeche "walk" karta hai, har level kha jaata hai — isi se slippage hoti hai.

Sabse kaam ki cheez hai imbalance dekhna. Agar bid side pe size bahut zyada hai versus ask side, to buy pressure hai aur price thoda upar jaane ki sambhavna. OBI formula $(Q_b - Q_a)/(Q_b + Q_a)$ isi ko $-1$ se $+1$ ke beech normalize karta hai. Lekin saavdhaan: displayed size fake bhi ho sakta hai (spoofing) — koi bada order dikhaake cancel kar deta hai. Isliye order book ke saath-saath tape (actual executed trades) bhi dekho — jo actually trade hua hai wahi sach hai.

Test yourself — Order Flow & Tape Reading

Connections