Market Microstructure

1. What Is Market Microstructure?

Market microstructure is the study of how markets operate at the granular level — bid-ask spreads, order book depth, tick sizes, lot sizes, and the mechanics of trade execution. It's the "plumbing" of financial markets that most retail investors never think about, yet it determines whether your trade executes at the price you see on screen.

2. The Order Book

When you look at a stock's price, you're seeing the last traded price (LTP). But the real action is in the order book — the queue of all pending buy and sell orders at various prices.

• Bid: The highest price someone is willing to pay
• Ask (Offer): The lowest price someone is willing to accept
• Spread: The difference between bid and ask

A liquid stock like Reliance might have a spread of ₹0.05. An illiquid small-cap might have a spread of ₹2 or more. That spread is a hidden cost you pay on every market order.

3. Bid-Ask Spread Dynamics

Spreads widen and narrow based on:

• Volatility: Higher volatility = wider spreads (market makers demand more compensation)
• Time of day: Spreads are widest at market open and close, narrowest mid-day
• Order book depth: If there are few orders near the best price, spreads widen
• Stock liquidity: Large-cap stocks have tighter spreads than small-caps

4. Tick Size and Price Bands

The tick size is the minimum price increment a stock can move:

• Most stocks: ₹0.05 per tick
• Stocks above ₹500: Some move in ₹0.10 increments
• Derivatives: Varies by contract (often ₹0.05 or ₹0.10)

Tick size matters for high-frequency strategies and for stocks with very tight spreads. A large tick size relative to the stock price can create artificial price barriers.

5. Lot Sizes and Market Depth

Lot size is the minimum number of shares you can trade in a single order for derivatives. In the cash market, you can buy 1 share, but in F&O, lot sizes are fixed (e.g., Nifty lot = 50 units, Bank Nifty lot = 15 units).

Market depth shows how many shares are available at each price level. A stock with deep markets can absorb large orders without significant price impact. A stock with shallow markets will move sharply on moderate-sized orders.

6. Slippage: The Hidden Cost

Slippage is the difference between the expected price and the actual execution price. It occurs because:

• By the time your order reaches the exchange, the best price may have moved
• Your order size may exhaust the available liquidity at the best price
• Other orders may have priority in the queue

For retail investors trading small quantities in liquid stocks, slippage is minimal. For large orders or illiquid stocks, slippage can be 1-3% or more.

7. Why Microstructure Matters to You

1. Execution quality: Understanding spreads helps you choose between market and limit orders
2. True cost: Brokerage + STT + spread + slippage = your real transaction cost
3. Strategy selection: Scalping strategies fail in stocks with wide spreads
4. Timing: Avoiding the open and close reduces spread costs