Limit Order Book Trading Strategy

Limit Order Book Trading Strategy: Video, Backtest and Example

In today’s computer-driven, fast-paced market, monitoring the limit order book may help you predict price movements. But what is the limit order book trading strategy?

The limit order book trading strategy is based on the order flow. The limit order book (LOB) is an electronic record maintained by an exchange of all buy and sell limit orders that come in for a given instrument.

In this post, we take a look at the limit order book trading strategy and we end the article

What is a limit order book trading strategy?

A limit order book (LOB), also known as the central limit order book (CLOB) is an electronic bookkeeping system maintained by an exchange, which shows all buy and sell limit orders that come in for a given instrument — stocks, futures, bonds, cryptocurrencies, etc. The limit order book trading strategy is simply trading based on the order flow.

limit order book trading strategy
An example in Tradingview of a limit order book.

Each exchange maintains an order book for every security listed on it. Every limit order someone submits to an exchange will be displayed on the order book with the following information:

  • The ticker symbol of the security
  • The order direction — a buy order or a sell order
  • The limit price
  • The trade size — in the case of a stock, the number of shares to buy or sell.

The order book is typically grouped into:

  • The buy limit orders (Bids) — from the highest to the lowest prices
  • The sell limit orders (Asks or Offers) — from the lowest to the highest prices

How do you trade based on limit order books?

To trade based on limit order books, you need to understand the concept of order flow and how it determines supply and demand imbalances. By watching the changes in order flow, you can predict short-term price changes.

If you are a day trader or a scalper, you can trade based on the limit order books by tracking the order flow. For example, if huge sell orders are coming in at lower prices, and the buy side is scanty, there’s a huge chance the price would drop.

How do you use limit orders effectively?

To trade effectively with limit orders, you need to monitor the order book to know the right price to set your limit order. It is best to set your order at a level a little before a huge order. This will help in two aspects:

  • Your order would get filled before the huge order
  • The huge order would be able to absorb further orders and prevent the price from moving aggressively against your position.

Limit order book example

In an order book, limit orders are arranged by the exchange on a price-time priority, such that the best prices are kept at the top, as follows:

  • On the bid (buy limit orders) side, prices are arranged from highest to lowest and according to the time the orders came in.
  • On the ask (sell limit orders) side, prices are arranged from lowest to highest and according to time.
Limit order book example
Limit order book example

What is an order book algorithm?

An order book algorithm is a matching algorithm in the order book that matches the incoming market order to the right limit order in the order book. The most common matching mechanism uses the price-time priority.

If a sell market order comes in, it matches the highest buy limit order (bid) that came in the earliest. If a buy market order comes in, it matches the lowest sell limit order (ask) that came in the earliest.

Limit order book trading strategy backtest – does it work?

We would love to provide you with a limit order book trading strategy, but unfortunately, we don’t. The reason is two-fold:

  • First, it’s extremely difficult to backtest.
  • Second, we don’t recommend such a strategy for retail traders (there are easier ways to make money in the markets).

How do you go about backtesting such a strategy with proper trading rules and settings? It requires a lot of data and statistics that you are unlikely to get hold of. And even if you have the data it would be difficult to backtest.

Furthermore, we believe such strategies are not suitable for retail traders. They are too complicated, based on too much gut feeling.

The limit order book trading strategy is way too similar to high-frequency trading and scalping – two trading methods we believe are a waste of time for 99.5% of all retail traders. We have explained why in the linked articles below:

What is the best option for retail traders (instead of wasting your time on a limit order book trading strategy)?

We believe the best option is to focus on traditional technical trading indicators and price action strategy. Of course, we assume that you backtest your trading ideas. We have backtested hundreds of ideas:

List of trading strategies

We have written over 1000 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.

The Amibroker code for the backtested positional trading strategy is included in the package.

The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.

The strategies are taken from our source of what are the different types of trading strategies. The strategies are an excellent resource to help you get some trading ideas.

The strategies also come with logic in plain English (plain English is for Python traders).

For a list of the strategies we have made please click on the green banner:

These strategies must not be misunderstood for the premium strategies that we charge a fee for:

FAQ limit order book trading strategy

Let’s end the article with a few frequently asked questions:

What is a limit order book trading strategy?

A limit order book trading strategy is a method of trading that involves tracking and analyzing the order book of a given market. It involves placing orders based on the current market conditions, as well as using the order book to predict future price movements.

This is a problematic strategy that is not suitable for most retail traders.

How do you read a limit order book?

To be good at reading the order book requires a lot of experience. Keep in mind that most of the action is noise.

How does limit order book trading work?

Limit order book trading works by placing orders based on the current market conditions and analyzing the order book. The trader will monitor the order book to identify potential trading opportunities based on the existing orders and to predict future price movements. This can be done manually or using automated trading algorithms.

We recommend backtesting before you even think about this. If you don’t backtest, you have no idea if you have a positive expectancy – you are trading blind.

Unfortunately, it isn’t easy to backtest a limit order book trading strategy. Thus, we believe you are better off if you focus your time and efforts on other strategies.

What are the advantages of limit order book trading?

The advantages of limit order book trading are that it can help traders to make more informed trading decisions and to reduce risk. Furthermore, it allows traders to take advantage of price movements in a timely manner and capitalize on market inefficiencies.

We believe this strategy has been made pretty efficient over the last decade due to giant leaps in computer technology.

Two decades ago, we used to trade similar strategies with reasonable success. However, we abandoned this strategy around 2005 because it was no longer time efficient.

What are the risks associated with limit order book trading?

The risks associated with limit order book trading include the potential for slippage and market manipulation. Slippage occurs when the price of an asset changes between the time a trader places an order and when it is filled. Market manipulation is when market participants attempt to artificially move the price of an asset to benefit their positions.

But, as mentioned earlier in the post, the main drawback is to backtest to find out if you have a trading edge in the first place.

How can I get started with limit order book trading?

To get started with limit order book trading, traders should familiarize themselves with the different order types and the order book itself.

Once they have done this, they can begin to track and analyze the order book to identify potential trading opportunities. Additionally, traders should research the different trading strategies and software tools available to help them with their trading.

But overall, we believe retail traders should put their focus elsewhere. For example, we have plenty of potentially profitable strategies that are much easier to implement than any limit order book trading strategy:

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