We introduced a lot of new concepts in the previous section, such as exchange order books (consisting of different kinds of orders sent by market participants), exchange matching algorithms, exchange market data protocols, and exchange order entry protocols. Let's formally discuss these in greater detail here.
Understanding algorithmic trading concepts
Exchange order book
The exchange order book maintains all incoming buy and sell orders placed by clients. It tracks all attributes for incoming orders—prices, number of contracts/shares, order types, and participant identification. Buy orders (or bids) are sorted from the highest price (best price) to the lowest price (worst price). Bids with higher prices have a higher priority as far as matching is concerned. Bids at the same price are prioritized depending on the matching algorithm. The simplest FIFO (First In First Out) algorithm uses the intuitive rule of prioritizing orders at the same price in the order in which they came in. This will be important later on when we discuss how sophisticated trading algorithms use speed and intelligence to get higher priorities for their orders and how this impacts profitability. Sell orders (or asks) are sorted from the lowest price (best price) to the highest price (worst price). Again, as regards asks at the same price, the matching prioritization method depends on the matching algorithm adopted by the exchange for the specific product, which we will expand upon in greater detail in the next section. Market participants are allowed to place new orders, cancel existing orders, or modify order attributes such as price and the number of shares/contracts, and the exchange generates public market data in response to each order sent by participants. Using the market data distributed by the exchange, market participants can get an accurate idea of what the order book at the exchange looks like (depending on what information the exchange chooses to hide, but we ignore that nuance for now).
Exchange matching algorithm
When incoming bids are at or above the best (lowest price) ask orders, then a match occurs. Conversely, when incoming asks are at or below the best (highest price) bid orders, then a match occurs. Incoming aggressive orders continue to match against existing passive orders in the book until one of these two conditions is met. Either the new aggressive order is fully matched, or the other possibility is that the remaining orders on the opposite side have prices worse than the incoming order price and, hence, the match cannot occur. This is because of the fundamental rule that an order cannot be matched at a price worse than the limit price it was entered at. Now, as far as orders at the same price level are concerned, the order of matching is dictated by what matching algorithm rules the exchange adopts.
FIFO matching
We briefly described the FIFO algorithm previously, but let's expand on it by showing an example. Assume the following state of an order book when the exchange bid orders A, B, and C were entered at price 10.00 in that order in time. So, at the same price, order A has a higher priority than order B, which has a higher priority than order C. Bid order D is at a worse price, 9.00. Similarly, on the ask side, order X was entered at price 11.00 before order Y, also at price 11.00. Hence, order X has a higher priority than order Y, and then ask order Z was entered at a worse price, 12.00:
|
BIDS |
ASKS |
|
Order A: Buy 1 @ 10.00 |
Order X: Sell 1 @ 11.00 |
|
Order B: Buy 2 @ 10.00 |
Order Y: Sell 2 @ 11.00 |
|
Order C: Buy 3 @ 10.00 |
Order Z: Sell 2 @ 12.00 |
|
Order D: Buy 1 @ 9.00 |
Assume an incoming sell order K for 4 shares @ 10.00 would match against order A for 1 share, order B for 2 shares, and order C for 1 share, in that order, under FIFO matching. At the end of the matching, order C would still have the remaining size of 2 shares at price 10.00 and will have the highest priority.
Pro-rata matching
Pro-rata matching comes in a variety of flavors and is usually implemented in slightly different ways. For the scope of this book, we provide some intuition behind this matching algorithm and provide a hypothetical matching scenario.
The underlying intuition between pro-rata matching is that it favors larger orders over smaller orders at the same price and ignores the time at which the orders were entered. This changes the market's microstructure quite a bit, and the participants are favored to enter larger orders to gain priority instead of entering orders as fast as possible:
|
BIDS |
ASKS |
|
Order A: Buy 100 @ 10.00 |
Order X: Sell 100 @ 11.00 |
|
Order B: Buy 200 @ 10.00 |
Order Y: Sell 200 @ 11.00 |
|
Order C: Buy 700 @ 10.00 |
Order Z: Sell 200 @ 12.00 |
|
Order D: Buy 100 @ 9.00 |
Consider a market state as shown earlier. For the sake of this example, the hypothetical order sizes have been raised by a factor of 100. Here, bid orders A, B, and C are at the same price, 10.00. However, when an incoming sell order of size 100 comes in for price 10.00, order C gets a fill for 70 contracts, order B gets a fill for 20 contracts, and order A gets a fill for 10 contracts, proportional to how big they are at that level. This is an overly simplified example that excludes complications related to fractional match sizes and breaking ties between orders with the same size, and so on. Also, some exchanges have a mix of pro-rata and FIFO, where part of the incoming aggressor matches using pro-rata, and part matches in FIFO order. But this should serve as a good basic understanding of how different pro-rata matching is compared to FIFO matching. A detailed examination of pro-rata matching and its impact is beyond the scope of this book, so we exclude it.
Limit order book
A limit order book is very similar in spirit to the exchange order book. The only difference is that this is built by the market participants based on the market data that is being sent out by the exchange in response to market participants sending orders to it. The limit order book is a central concept in all algorithmic trading, and one often found in all other forms of trading as well. The purpose is to collect and arrange bids and offers in a meaningful way to gain insight into the market participants present at any particular time, as well as gain insight regarding what the equilibrium prices are. We will revisit these in the next chapter when we dig deeper into technical analysis. Depending on what information the exchange decides to make available to all market participants via public market data, the limit order book that the client builds can be slightly different from what the order book at the exchange matching engine looks like.
Exchange market data protocols
Exchange market data protocols are not the focus of this book, so a rigorous treatment of this topic is beyond the scope of this book. These market data protocols are outgoing communication streams from the exchange to all market participants that are well-documented for new participants to build their software applications to subscribe, receive, decode, and check for errors and network losses. These are designed with latency, throughput, error tolerance, redundancy, and many other requirements in mind.
Market data feed handlers
Market data feed handlers are software applications that market participants build with a view to interfacing with the specific exchange market data protocol. These are able to subscribe, receive, decode, and check for errors and network losses, and are designed with latency, throughput, error tolerance, redundancy, and many other requirements in mind.
Order types
Most exchanges support a variety of orders that they accept from market participants. We will discuss a few of the most common types in this section.
IOC – Immediate Or Cancel
These orders never get added to the book. They either match against existing resting orders to a maximum of the IOC order size, or the rest of the incoming order gets canceled. If no resting order is available at a price that the IOC can match against, then the IOC is canceled in its entirety. IOC orders have the benefit of not resting in the book post matching and causing additional complexity with order management in trading algorithms.
GTD – Good Till Day
These orders get added to the book. If they match fully against existing resting orders in the book, then they don't get added, otherwise the remaining quantity on the order (which can be the entire original quantity if there's no partial match) gets added to the book and sits as resting orders that the incoming aggressors can match against. The benefits of GTD orders are that they can take advantage of FIFO matching algorithms by having better priorities than orders that just showed up in the book, but require more complex order management in trading algorithms.
Stop orders
Stop orders are orders that aren't in the book until a specific price (called the stop price) is traded in the market, at which point they become regular GTD orders at a pre-specified price. These orders are great as exit orders (either to liquidate a losing position or to realize profit on a winning position). We will revisit these orders after we have explained what having a losing or winning position means and what exiting a position means.
Exchange order entry protocols
Exchange order entry protocols are how market participant software applications send order requests (new, cancels, modifies) and how the exchange replies to these requests.
Order entry gateway
Order entry gateways are the market participant client applications that communicate with the exchange matching engine over the order entry protocols. These have to deal with order flow in a reliable manner, sending orders to the exchange, modifying and canceling those orders, and getting notifications when these orders are accepted, canceled, executed, and so on. Oftentimes, market participants run a second variant of order entry gateways that simply receive order-executed notifications to check consistency against the primary order entry gateway order flow. These are called drop-copy gateways.
Positions and profit and loss (PnL) management
Orders that get executed cause market participants to have positions in the instrument that they got executed, for the amount the order executed, and at the price of the execution (limit orders can match at better prices than they were entered for, but not worse). A buy side execution is called having a long position, while a sell side execution is called having a short position. When we have no position at all, this is referred to as being flat. Long positions make money when market prices are higher than the price of the position, and lose money when market prices are lower than the price of the position. Short positions, conversely, make money when market prices go down from the price of the position and lose money when market prices go up from the price of the position, hence, the well-known ideas of buy low, sell high, and buy high, sell higher, and so on.
Multiple buy executions, or multiple sell executions for different amounts and prices, cause the overall position price to be the volume weighted average of the execution prices and quantities. This is called the Volume Weighted Average Price (VWAP) of the position. Open positions are marked to market to get a sense of what the unrealized Profit and Loss (PnL) of the position is. This means that current market prices are compared to the price of the position; a long position where market prices have gone up is considered unrealized profit, and the opposite is considered unrealized loss. Similar terms apply to short positions. Profit or loss is realized when an open position is closed, meaning you sell to close a long position and you buy to close a short position. At that point, the PnL is given the term realized PnL. The total PnL at any point is the total of the realized PnLs so far and the unrealized PnLs for open positions at the market price.
