Understanding Order Types and Trade Types
When you trade, you’re the boss! You send instructions to brokers, exchanges, and DeFi protocols, and they carry out your instructions. The trouble is… they do not know your intent. They only know what to do based on the instructions you provide, so it’s really important to understand how to give accurate instructions.
I’m going to explain trade types and some basic order types. Then we’ll discuss maker & taker orders and how they fit into DeFi trading.
The basic trade types are buy, sell, short, and buy to cover.
Buy and Sell orders are the trade types that are the most well-known. If I want to buy bitcoin, then I can put money on an exchange and I can enter a buy order to buy bitcoin, and then after the order is executed, I have bitcoin. I can HODL that bitcoin forever, or I can stake that bitcoin somewhere to earn a little yield. Holding a position that you bought is also referred to as being ‘Long’ the position.
Eventually I might sell that bitcoin. I submit a sell trade on the exchange, and after my order is executed then I don't have bitcoin anymore. Instead I have the money that I sold it for.
When you short, you are selling something that you don’t previously own! You can sell something that you don't own, if you can find someone to borrow it from. If I borrow bitcoin from somebody I can sell that bitcoin. Then if it goes down in price, and I buy it and return it to the person I borrowed from. I can profit the difference between what I originally sold it for, and what I buy it back for. But if it goes up, I would lose the difference instead.
The key takeaway is to short something I have to borrow it and then sell. That gives me a ‘negative’ position in the asset (I have a loan in the asset that has to be repaid).
- Buy to Cover
When I’m ready to repay the loan (because the asset depreciated and made the loan easy to repay, or because the asset appreciated and I need to cut my exposure before it destroys me) then I need to buy the asset to repay the loan. If the loan is facilitated through a traditional broker, the trade type is ‘buy to cover’.
In DeFI, the loan could easily be separate from where I’m trading (e.g. I borrowed WBTC from Compound and sold it on Uniswap, so now I need to buy some WBTC to repay the loan on Compound). In Uniswap this looks like a normal buy order, but because my intent is to repay the loan, I should still think of it as a ‘Buy to Cover’ trade.
With crypto assets, you could buy something else with the asset. I could borrow bitcoin, and I could use that bitcoin to buy ETH. I don't have the Bitcoin anymore but I do have Ethereum. Now I'm short Bitcoin, and I'm long ETH. Then I can just hold the ETH to ride the EIP-1559 rocket. Then sell it, eventually, for bitcoin and then repay the bitcoin loan. When I sell the ETH, that’s a sell trade for the ETH, but it’s a Buy to Cover for the bitcoin.
I could take the ETH and buy something else with it. Let’s say BANK, so I can participate in the Bankless DAO. Now I’m short bitcoin, neutral ETH (I bought and then sold, so no exposure anymore), but long BANK.
Order types are how you send your trade to the market. There's a lot more order types than there are trade types. The basic order types are a market order, a limit order, and a stop order.
- Market Order
I'm sending the order to the market and I'm saying “hey, what do you got?” and taking whatever price they give me.
- Limit Order
I'm sending the order to the market, but giving them a specific price. So I'm saying “let me buy bitcoin if it drops below 32,000”. If it never goes below 32,000 then I don't get any bitcoin, but I get my money back when I cancel the order.
- Stop order
Stop order is triggered by a particular price. I want to buy bitcoin, but only if it breaks out above 43,000. So I submit a buy stop order at 43,000. If bitcoin breaks out above 43,000, it will convert into a market order and it will buy at the market price.
I can also use the stop order to close a position. I already have Bitcoin, and I bought it at 42,000, and I want to sell it if it drops below 38,000. I can enter an order that says “if bitcoin drops below 38,000 I want to sell it”. That would be a sell stop order, triggered by the price of bitcoin falling below 38,000. When that happens, then it converts into a market order and sells my bitcoin.
In both of the stop order examples that I gave, when the stop is triggered it converts into a market order. That might be good to protect me from a downturn, but make me vulnerable to selling into a flash crash. If my broker or exchange supports it, I can instead use a stop limit order. I submit a stop limit order with two prices. So I could say “if bitcoin drops below 38,000 I want to set a limit order for 37,000”. So when bitcoin drops below 38,000, it will submit a limit order at 37,000. If it drops below 37,000 then I don't actually want to sell, that's too big of a drop. I'd rather buy the dip.
Maker or Taker?
Crypto exchanges, whether centralized or decentralized, care a lot about how much liquidity is available for their customers. If you think of the exchange as a market where you’re buying financial products, then liquidity is how much product is available on the shelf at a particular price. If I can get 1 bitcoin at 42000 with no slippage, that’s a better experience for me than if an attempt to buy 1 bitcoin were to push the market price up to 45000. The exchange wants to encourage liquidity, and they do that by differentiating between orders that add liquidity (put products on the shelf) versus orders that remove liquidity (take products off the shelf).
- Taker Order
A taker Order is any order that removes liquidity. Market Orders are always taker orders. Limit orders depend on where the limit price falls relative to the market. If there is liquidity available at the stated price and it fills right away, then it’s a taker order.
- Maker Order
Maker order adds liquidity. With a limit order, if there is no liquidity at the stated price then the limit order is adding liquidity (More inventory is available to people on the opposite side of the trade as you). If a limit order is only partially filled and the rest sits on the order book, then the part filled immediately was a taker order and the part left sitting on the order books is a maker order.
Because crypto exchanges value liquidity, they have different pricing for maker orders versus taker orders. I might pay 0.10% (ten basis points) on a taker order but only 0.02% (two basis points) on a maker order. That’s a limited incentive to use maker orders instead of taker orders.
When it comes to DeFi, most decentralized exchanges now use an automated market maker (AMM) model with no order book. Your order goes to the market, and takes available liquidity, so it's always a taker order. If you're a liquidity provider then you're a maker; you submit your ‘inventory’ into the liquidity pool. You're basically lining up maker orders and saying “I’ll provide liquidity to the market at whatever price”. And takers are paying trading fees to the makers. If there is enough trading activity, the makers could be well-compensated for their risks. If there is not enough trading activity, or if the risks are particularly high, the makers may need additional compensation (yield farming rewards) to encourage them to hold inventory and provide it to the market.
Thank you for joining me on Savage Corner, where finance and crypto meet!
Understanding trade and order types gives you a better understanding of what’s happening ‘under the hood’ when you trade in DeFi or provide liquidity to various DeFi protocols. My goal today was to provide you with insight into trade and order types, to give you more control over what happens when you trade.
Did you know that if you borrow on any DeFi money market protocol (e.g. Compound, Anchor, Aave) and then sell the asset for something else, that you are short the asset you borrowed? Did you know that when you LP funds, you’re a market maker?
If this has been informative to you, please share with a friend! If it was all review, but you know somebody that really needs to understand these concepts, pass it on gently.
Not financial or tax advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This newsletter is not tax advice. Talk to your accountant. Do your own research.
Disclosure. From time-to-time I may add links in this newsletter to products I use. I may receive commission if you make a purchase through one of these links. Additionally, the Savage Corner writers hold crypto assets and actively trade in certain markets.
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