Trading Skills

order driven market

What is an order-driven market?

An order-driven market is a financial market where all buyers and sellers indicate the price at which they wish to buy or sell a particular security, and the amount of security they wish to buy or sell. This trading environment is the opposite of quote-driven markets, which only display bids and asks from designated market makers and experts for the particular security being traded.

key takeaways

  • In an order-driven market, trades are based on the requirements of buyers and sellers, showing the bid and ask prices they want and the number of shares they want to trade.
  • This is in contrast to quote-driven markets, where trades are determined by market makers – traders and specialists looking to fulfill orders from their inventory or match them with other orders.
  • Order-driven markets offer two basic types of orders: market orders and limit orders.
  • Order-driven markets are seen as less liquid but more transparent than quote-driven markets.

Understanding Order-Driven Markets

An order-driven market consists of a continuous stream of buy and sell orders from market participants. Without a designated liquidity provider, the two basic types of orders are market and limit orders. In a quote-driven market, by contrast, a designated market maker provides bids and offers that other market participants can trade.

The biggest advantage of participating in order-driven markets is transparency, as the entire order book is displayed to investors who wish to access this information. Most exchanges charge a fee for such information. On the other hand, order-driven markets may not have the same degree of liquidity as quote-driven markets, where experts and market makers must trade at their published bid and ask prices.

Stock exchanges such as the NYSE and Nasdaq are considered hybrid markets – a combination of order-driven and quote-driven markets.

How Informed Trading Affects Order-Driven Markets

In an order-driven environment, where traders can choose between market orders that require liquidity and limit orders that provide liquidity, informed trading activity can actually increase liquidity.

The higher the proportion of informed traders represented by bid-ask spreads and market elasticity, the greater the liquidity. However, informed traders have no influence on the price impact of orders. Limit orders have about four times less impact on price than market orders.

How order-driven environments rank buy and sell orders

The order-driven trading system sorts buy and sell orders based on price, matching the highest ranked orders with the lowest order amount (if possible). If there are shares left to buy or sell in a given order, the trading system matches that order with the next highest-ranked sell or buy order.

The first rule in order priority is price priority, followed by the second priority rule, which determines how orders of the same price are ordered. The first order that reaches the best price usually takes precedence over other orders, although sometimes the trading system trades the displayed quantity before the hidden quantity at the same price.

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