QQ 101, 2 min read
Bid, ask and the order book
After this lesson you can
- Work out the cost of a round trip from a quote
- Choose between a market order and a limit order
- Explain where slippage comes from
Every market quotes two prices. The bid is the highest price someone will pay right now, and the ask is the lowest price someone will sell at. The ask is always above the bid. The gap is the spread.
If gold is quoted 2,000.00 bid and 2,000.30 ask, you can buy at 2,000.30 and sell at 2,000.00. Buy and sell straight away and you have lost 0.30 per ounce without the market moving. Every round trip pays that spread.
The order book
On an exchange, the bids and asks waiting to trade are listed in an order book: each price level and how much is waiting there. The amount near the best prices is called depth.
Two kinds of order
A market order says: trade now at the best available price. It always fills, and you pay the spread.
A limit order says: trade only at this price or better. It may never fill. If it does, you did not pay the spread, because you were the one waiting.
Slippage
If your order is bigger than what is waiting at the best price, the rest fills at the next level, which is worse. The difference between the price you expected and the price you got is slippage. It grows with order size and when the market is moving fast.
A backtest that fills every order at the last traded price, with no spread and no slippage, is describing trades nobody could have made. The terminal's cost model is described in Fills and costs.
Key points
- Every round trip pays the spread
- A market order buys certainty of a fill; a limit order buys a price
- Slippage grows with order size and with speed of the market
Check your understanding
Gold is quoted 2,000.00 bid, 2,000.30 ask. You buy one ounce and sell it at once. What happens?
Which order is guaranteed to fill?
Further reading
- Harris, L. (2003). Trading and Exchanges. Oxford University Press. Chapters on orders, order-driven markets and liquidity.
- Almgren, R. and Chriss, N. (2001). "Optimal Execution of Portfolio Transactions." Journal of Risk 3(2). The standard model of how trade size moves the price.