Chapter 2: The Critical Components of a Trading System

In the previous chapter, we learned how to create high-frequency trading (HFT) strategies. In this chapter, we are going to study how to convert these strategies into real-time software that will connect to an exchange to actually apply the theory that you've previously learned. We will describe the functioning of a trading system capable of trading assets.

In this chapter we will cover the following topics:

• Understanding the trading system
• Making a trading system trade with exchanges
• Order book management
• Strategy making decisions on when to trade

By the end of this chapter, you will be capable of designing a trading system, connecting a trading system to an exchange, and building a limit order book.

Understanding the trading system

Designing a trading system for HFT trading requires much more than knowledge of programming and trading. The following chapters of this book will describe these parts in depth, which will give you an edge in designing an HFT system. In this section, we are going to talk about the fundamentals of trading system design. One of the most critical parts of designing a system is having a detailed description of the requirements. The goal of a trading system is to support your trading ideas. Any trading strategies start by getting data and end up with making a decision based on this data. A trading system will oversee collecting market data (that is, price updates) and sending orders to the exchange. Additionally, it will collect answers from the exchange containing information on the orders. These market updates could be representing any state of the orders: canceled, rejected, filled, or partially filled. It will also compute metrics measuring the performance...

Making a trading system trade with exchanges

A trading system contains a number of functional components that are responsible for trading and risk management, as well as monitoring the trading process on one or more exchanges. A trading strategy becomes a part of the trading system once it is coded. As input, you'll need price data, and as output, your orders. This will give out trading signals. We'll need gateways to finish this flow because they're the most important components.

The functional components of a trading system, the gateway's interface, and the trading system's interaction with the outside world are depicted in the following diagram:

Figure 2.3 – The functional components of a trading system

The gateways gather and send orders based on pricing and market reactions. Their primary function is to establish a link and translate data received from the outside world into the data structure needed by the trading system...

Order book management

The primary goal of data handling is to copy the limit order book from the venues into your trading system. The book builder will be in charge of gathering the pricing and categorizing them for your tactics in order to integrate all of the many books you obtain.

The pricing changes are transformed by the gateway and then passed to the book builder, as shown in the following diagram. The book builder will use the books that the gateways have received from the venues, as well as gather and sort any pricing changes:

Figure 2.5 – Book builder getting price updates from Gateway IN

In the following diagram, we use an example of an order book for a given financial product. The order book will contain two parts, one for the bids and one for the offers. For each part, we will store the orders represented by the venue, the volume, and the price. Every venue will send its own order books. The goal of the book builder is to create a book...

Strategy making decisions on when to trade

The trading strategy is the system's brain. This is where we will put our algorithm that represents our trading concept into action. Let's take a look at the diagram:

Figure 2.7 – Trading strategy receiving data from the book builder to make a decision on when to trade

The diagram shows that the trading strategy is divided into two main components, signal and execution:

• The signal component of this strategy only focuses on generating signals. However, having the intention (a signal) does not guarantee you will get the liquidity you are interested in. For instance, in HFT, it is highly likely your orders will be rejected because of the speed of your trading.
• The execution part of the strategy will take care of handling the response from the market. This part decides what to do for any responses from the market. For instance, what should happen when the order is rejected? You should continue...

Summary

We learned how to create a trading system in this chapter. The trading system we created includes all of the necessary components for you to design a trading system and start trading.

It takes years to learn how to construct a trading system. Because of the difference between the asset classes, it is likely that you will become an expert in one asset class rather than another. We created the bare minimum of features that a trading system should have. We must learn how to link this component to a trading system in order for it to be completely functioning.

In the following chapters, we will explain in detail how trading systems should be implemented and especially related to the operating system and the hardware. In the next chapter, we have more pieces of knowledge to learn about the trading exchange.