Going through the modern electronic trading exchange

The first trading exchange was the Amsterdam Stock Exchange, which began in 1602. Here, the trading happened in person. The applications of technology to trading included using pigeons, telegraph systems, Morse code, telephones, computer terminals, and nowadays, high-speed computer networks and state-of-the-art computers. With the passage of time, the trading microstructure has evolved into the order types and matching algorithms that we are used to today.

Knowledge of the modern electronic trading exchange microstructure is important for the design of algorithmic strategies.

Order types

Financial trading strategies employ a variety of different order types, and some of the most common ones include Market orders, Market with Price Protection orders, Immediate-Or-Cancel (IOC) orders, Fill and Kill (FAK) orders, Good-'Till-Day (GTD) orders, Good-'Till-Canceled (GTC) orders, Stop orders, and Iceberg orders.

For the strategies that we will be exploring in this book, we will focus on Market orders, IOC, and GTC.

Market orders

Market orders are buy-or-sell orders that need to be executed instantly at the current market price and are used when the immediacy of execution is preferred to the execution price.

These orders will execute against all available orders on the opposite side at the order's price until all the quantity asked for is executed. If it runs out of available liquidity to match against, it can be configured to sit in the order book or expire. Sitting in the book means the order becomes a resting order that is added to the book for other participants to trade against. To expire means that the remaining order quantity is canceled instead of being added to the book so that new orders cannot match against the remaining quantity.

So, for instance, a buy market order will match against all sell orders sitting in the book from the best price to the worst price until the entire market order is executed.

These orders may suffer from extreme slippage, which is defined as the difference in the executed order's price and the market price at the time the order was sent.

IOC orders

IOC orders cannot execute at prices worse than what they were sent for, which means buy orders cannot execute higher than the order's price, and sell orders cannot execute lower than the order's price. This concept is known as limit price since that price is limited to the worst price the order can execute at.

An IOC order will continue matching against orders on the order side until one of the following happens:

• The entire quantity on the IOC order is executed.
• The price of the passive order on the other side is worse than the IOC order's price.
• The IOC order is partially executed, and the remaining quantity expires.

An IOC order that is sent at a price better than the best available order on the other side (that is, the buy order is lower than the best offer price, or the sell order is higher than the best bid price) does not execute at all and just expires.

GTC orders

GTC orders can persist indefinitely and require a specific cancellation order.

Limit order books

The exchange accepts order requests from all market participants and maintains them in a limit order book. Limit order books are a view into all the market participant's visible orders available at the exchange at any point in time.

Buy orders (or bids) are arranged from the highest price (that is, the best price) to the lowest price (that is, the worst price), and Ask orders (that is, asks or offers) are arranged from the lowest price (that is, the best price) to the highest price (that is, the lowest price).

The highest bid prices are considered the best bid prices because buy orders with the highest buy prices are the first to be matched, and the reverse is true for ask prices, that is, sell orders with the lowest sell prices match first.

Orders on the same side and at the same price level are arranged in the First-In-First-Out (FIFO) order, which is also known as priority order – orders with better priority are ahead of orders with lower priority because the better priority orders have reached the exchange before the others. All else being equal (that is, the same order side, price, and quantity), orders with better priority will execute before orders with worse priority.

The exchange matching engine

The matching engine at the electronic trading exchange performs the matching of orders using exchange matching algorithms. The process of matching entails checking all active orders entered by market participants and matching the orders that cross each other in price until there are no unmatched orders that could be matched – so, buy orders with prices at or above other sell orders match against them, and the converse is true as well, that is, sell orders with prices at or below other buy orders match against them. The remaining orders remain in the exchange matching book until a new order flow comes in, leading to new matches if possible.

In the FIFO matching algorithm, orders are matched first – from the best price to the worst price. So, an incoming buy order tries to match against resting sell orders (that is, asks/offers) from the lowest price to the highest price, and an incoming sell order tries to match against resting buy orders (that is, bids) from the highest price to the lowest price. New incoming orders are matched with a specific sequence of rules. For incoming aggressive orders (orders with prices better than the best price level on the other side), they are matched on a first-come-first-serve basis, that is, orders that show up first, take out liquidity and, therefore, match first. For passive resting orders that sit in the book, since they do not execute immediately, they are assigned based on priority on a first-come-first-serve basis. That means orders on the same side and at the same price are arranged based on the time it takes them to reach the matching engine; orders with earlier times are assigned better priority and, therefore, are eligible to be matched first.

In this section, we learned about the order types and exchange matching engine of the modern electronic trading exchange. Now, let's proceed toward the next section, where we will learn about the components of an algorithmic trading system.