2. The order book and the spread: the anatomy of liquidity

Theory 2: How trading actually works

The price of a share does not 'exist' anywhere. There is no server holding it and no authority publishing it. It is the result of aggregating thousands of pending limit orders on both sides.

Every time you send a limit order that is not filled instantly, it does not disappear. It waits, visible — or partially visible — to the rest of the market, in a structure called the order book.

Understanding the order book means understanding, quite literally, what the price is made of at any instant.

The two columns of the book

The book is organized into two columns.

• The buy side (the bid) lists, from highest to lowest price, all pending limit buy orders. The top line, the best bid, is the highest price anyone is willing to pay right now.
• The sell side (the ask, or offer) lists, from lowest to highest price, all pending limit sell orders. The top line, the best ask, is the lowest price anyone is willing to accept right now.

The difference between the best ask and the best bid is the spread. In practice it represents the immediate cost of wanting to trade right now:

• If you buy with a market order, you pay the ask.
• If you sell with a market order, you receive the bid.

And the difference between the two goes, almost always, to the market maker who was willing to be your counterparty in both directions.

Why some spreads are wide and others narrow

The size of the spread is not arbitrary: it directly reflects how many people want to trade that asset at that moment.

A very liquid stock, with millions of shares traded per day, usually has a spread of just a few cents. Competition between buyers and sellers is so fierce that nobody can afford to ask much more than the market price without losing the trade to another participant offering better.

A thinly traded stock, by contrast, can have a much wider spread in relative terms. Few participants are willing to take on the risk of being the counterparty, and whoever does demands greater compensation for it.

Depth: what sits behind the top line

But the order book is not just one line on each side. It has depth: further price levels with more orders stacked behind them.

Suppose you want to buy more shares than are available at the best offer. Your market order does not stop there: it keeps 'walking the book', buying at the next price level, and the next, until your full quantity is filled.

The average price you end up paying can be noticeably worse than the price you saw before sending the order, especially in assets with little depth. That difference between the expected price and the price actually obtained is called slippage.

It is one of the reasons — along with commissions — why no real strategy, not even the best one on paper, ever executes at exactly the price shown on a chart.

How the big buyers buy

Large fund managers are aware of this problem, which is why they do not send one giant order all at once. They split it into smaller orders spread out over minutes or hours, using execution algorithms such as VWAP or TWAP, which try to track the market's volume or time average.

The aim is twofold: to minimize how far they 'walk the book', and how much of their intention they reveal to the other participants.

This is one of the areas where algorithmic trading is not about predicting the future, but simply about executing an already-made decision better. That is as relevant for a multi-billion fund as it is hard to replicate for an individual with a small account. But the underlying principle — split large orders so you do not move the price against yourself — applies at any scale.

Tick size: why the spread has a floor

Finally, neither the bid nor the ask can move by any arbitrary amount. Each market defines a tick size: the minimum price increment allowed between two consecutive levels of the book.

In US stocks at 'normal' price ranges the tick is usually one cent. In other markets, or at certain price ranges, it may differ.

The tick size effectively sets the minimum possible spread. However liquid a stock is, the spread can never be smaller than one tick, because there is no valid intermediate price between the best bid and the best ask.