How does a limit order book work and what determines which orders get filled first?

Question

AcadiFi · Accepted Answer

A limit order book (LOB) is the central mechanism in an order-driven market. It collects all outstanding buy and sell limit orders and matches them using **price-time priority**.

```mermaid
graph TB
    subgraph "Limit Order Book — Harlow Corp"
    direction TB
    A["SELL Side (Asks)"] --> B["$52.10 x 200 — arrived 10:01"]
    A --> C["$52.05 x 500 — arrived 9:58"]
    A --> D["$52.00 x 300 — arrived 9:55"]
    E["BUY Side (Bids)"] --> F["$51.95 x 400 — arrived 9:50"]
    E --> G["$51.90 x 600 — arrived 9:52"]
    E --> H["$51.85 x 150 — arrived 9:54"]
    end
    style D fill:#c9a84c,color:#000
    style F fill:#3b82f6,color:#fff
```

**Price-Time Priority Rules:**
1. **Price priority** — the best-priced orders execute first. For buys, the highest bid gets priority. For sells, the lowest ask gets priority.
2. **Time priority** — among orders at the same price, the order that arrived earliest fills first.

**Walkthrough Example:**

The book for Harlow Corp shows the best ask at $52.00 (300 shares) and the best bid at $51.95 (400 shares). The **spread** is $0.05.

Now suppose a new market buy order for 400 shares arrives:
- First, it fills against the 300 shares at $52.00 (cheapest ask)
- Still needs 100 more shares, so it moves up to the next level: $52.05, filling 100 of the 500 shares there
- Result: buyer pays a **volume-weighted average** of (300 x $52.00 + 100 x $52.05) / 400 = **$52.0125**
- The remaining 400 shares at $52.05 stay on the book

**Key concepts for the exam:**

| Term | Definition |
|---|---|
| Bid-ask spread | Difference between best bid and best ask |
| Market depth | Total quantity available at each price level |
| Price improvement | When an order fills at a better price than the standing quote |
| Aggressive order | Crosses the spread to execute immediately |
| Passive order | Sits on the book providing liquidity |

**Hidden orders and icebergs:** Some exchanges allow traders to hide part of their order size. Only the displayed portion has time priority — the hidden portion is treated as a new order when the displayed portion fills.

Understanding the limit order book is essential because many CFA Level I questions test whether you know which order fills first and at what price when multiple orders interact.

Check out our CFA equity course for video walkthroughs of order matching scenarios.

How does a limit order book work and what determines which orders get filled first?

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Related Questions

Practice Questions

Term	Definition
Bid-ask spread	Difference between best bid and best ask
Market depth	Total quantity available at each price level
Price improvement	When an order fills at a better price than the standing quote
Aggressive order	Crosses the spread to execute immediately
Passive order	Sits on the book providing liquidity