Institutional investors and their trading algorithms leave their mark on the order book. The market microstructure helps to recognize these patterns and classify market movements.
• Large market participants often break orders into smaller pieces
• Iceberg orders can indicate hidden liquidity
• Spoofing only simulates liquidity and is prohibited
Why large market participants split their orders
Orders of different sizes come together on the financial markets. While private investors usually trade small positions, institutional orders can be so large that immediate execution would significantly shift the price.
Therefore, larger orders are often algorithmically broken down into smaller parts and executed over a longer period of time. The market microstructure describes this interaction between liquidity and order execution as the basis for price formation. For market observers, however, the division of large orders creates a fundamental problem: large players are not directly visible – their activity can only be derived indirectly via the order book and the order flow.
The order book as a snapshot of liquidity
The order book shows all currently visible buy and sell orders in a market. The difference between the two sides is often referred to as market depth. In practice, however, the order book only provides a partial picture of actual market activity. In addition to visible orders, there is additional, undisclosed liquidity, for example through internal trading venues or over-the-counter executions.
Order flow analyzes use the visible structures to identify possible imbalances between supply and demand. However, the following applies: The order book does not show any safe signals, only probabilities.
Iceberg orders and hidden liquidity
Iceberg orders are a well-known phenomenon. Only a small part of a large order is placed visibly in the order book, while the rest is gradually added. For other market participants, this looks like a normal order, even though there is significantly more volume in the background. Repeated executions at the same price level can therefore be an indication of larger, longer active market participants – but this is not clear evidence.
Liquidity Gaps: When there is a lack of liquidity in the order book
In addition to areas of high liquidity, zones with low market depth also play an important role. In these so-called liquidity gaps, even smaller orders can trigger larger price movements.
The reason lies in the so-called market impact: If there are hardly any counter orders at a price level, the market must quickly go through several price levels until sufficient liquidity is found. Such areas are considered zones of increased dynamism in trading, but do not provide reliable directional forecasts.
Spoofing: When liquidity is only faked
But not every visible order in the order book is real. In so-called spoofing, large buy or sell orders are placed without any intention of execution. The US authority CFTC defines spoofing as the placing of orders with the aim of deleting them before execution. The aim is to create an artificial market depth and encourage other market participants to react incorrectly. Such practices are prohibited and have been prosecuted several times by US authorities in recent years.
Footprint charts and CVD as a supplement to the order book
Since the order book alone only shows a section, many traders use additional tools. Footprint charts visualize the price levels at which transactions actually took place. The Cumulative Volume Delta (CVD), on the other hand, measures whether aggressive buyers or sellers dominate the market over time.
Both methods do not provide any forecasts, but they do help to better classify order flow and market structure.
What liquidity analysis can do – and what it can’t
The analysis of the order book and order flow can provide information about market activity, especially in the interaction of liquidity, volume and price movements. At the same time, the picture remains incomplete because large parts of trading take place over-the-counter or covertly.
Liquidity analysis is therefore particularly suitable for classifying current market phases, but not as the sole basis for forecasts. Those who use them do not look at clear signals, but rather probabilities in market behavior.
Jonas Vogt, editorial team at finanzen.net