Limit Order Books, Bid-Ask Spreads, and Microprice

Summary

This article explains how market orders and limit orders interact in an electronic market. Limit orders state a desired price and add available liquidity to the limit order book; market orders seek immediate execution against that liquidity and consume it. The best available bid and ask define the quoted spread, which represents an immediate round-trip cost before other transaction costs. The text links narrower spreads with more liquid securities and wider spreads with less liquid ones.

It also introduces the midpoint of the best bid and ask as a simple representative price, while noting that it can be misleading when displayed quantities differ substantially. A microprice weights the two quotes using their available volumes, shifting toward the side with less displayed liquidity. These concepts are presented as market-structure foundations for a later discussion of executing large orders while limiting price impact. The article gives conceptual explanations rather than empirical measurements, and the microprice is an estimate based on top-of-book quotes and sizes.

Key ideas

• Limit orders rest at specified prices and provide liquidity, while market orders trade immediately and consume it.
• The best bid and ask define the quoted spread, which contributes to the cost of an immediate round trip.
• More liquid securities generally have narrower spreads, while less liquid securities tend to have wider spreads.
• The midpoint averages the best quotes but can overlook differences in displayed quantities.
• The microprice weights the quotes by their displayed volumes and shifts toward the side with less liquidity.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.