Why do I often see some very deep limit buys and limit sells in a limit book? For instance the bid-ask may be \$39.00-39.01 but I see some bids at \$20 or even \$10 and some ask at \$60 or even \$500. What's the point of doing so? To capture some potential long-tail events?
Answer
I can think of 3 reasons:
1) Queue position
2) To be on the other side when an alogrithm has a disastrous error, which happens quite often on singular stocks and doesn't get reported (but someone will get fined) . I've seen cases where the price will drop over 99% almost instantaneously. For this to occur a backfiring algo will clear out the entire bid schedule, but keep issuing market orders, and a smart automated market making algo will take the other side for 1 cent.
3) To capture errors by manual traders. For example if they enter an extra zero on their limit order.
For (1) to be true, the orders must be relatively near to the insides. For example an order 8 levels above the insides is likely to be for (1) and (1) only. An order many hundreds of levels away is not due to (1) but due to other factors.
All else held equal, the probability that (2) is the reason is up to the exchange in question. Some exchanges will reverse the trades when an algo breaks down making such orders futile, others won't.
On some exchanges, (3) is not even possible since the exchange matching engine will guarantee that you receive the best possible price for your trade.
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