Order book dynamics in high frequency trading

1
Gaurav Raizada,
Director at iRageCapital Advisory Pvt. Ltd.
Faculty at QuantInsti Quantitative Learning Pvt. Ltd.
02-JUNE -2015
Mumbai
Order Book Dynamics in High
Frequency Trading

2
Limit Order Book
• Indian exchanges are order-driven markets.
• Most newly organized trading systems are
electronic order-driven markets.
• All order-driven markets use order
precedence rule and trade pricing rule.
Workshop on Algorithmic & High Frequency Trading

3
Resolution Parameters of LOB
• Lot Size- Smallest Quantity Order that can be placed
in Order Book
• The tick size - All orders must arrive with a price that
is specified to the precision of a tick size.
• The best bid price - highest price among active buy
orders
• The best ask price - lowest price among the active
sell orders.
• The bid-ask spread - difference between the best ask
and the best bid

4
Order Precedence Rules
• Price priority
– Should a trader be allowed to bid below the
best bid, above the best ask?
• Time precedence
– Is time precedence maintained for subsequent
orders at the best bid or offer? Why? Why not?
– How can a trader keep his bid or offer “live”?
– The minimum tick size is the price a trader has
to pay to acquire precedence.

5
More on Price Precedence
• Price priority
o Market orders always rank above limit orders.
o Limit buy orders with high prices have priority
over limit buy orders with low prices
o Limit sell orders with low prices have priority
over limit sell orders with high prices.

6
Time Precedence
• Under time precedence, the first order at a
given price has precedence over all other
orders at that price. Gives orders precedence
according to their time of submission.
• The pure price-time rule uses only price
priority and time precedence.

7
Order Types
Exchanges support various order types in order
to cater to needs of traders and investors. The
order types can be broadly divided into the
following categories –
• Time Conditions
• Price Conditions
• Other (including conditionality) Conditions

8
Time Conditions
• GTC - A Good Till Cancelled (GTC) order is an order that
remains in the system until it is cancelled by the Trading
Member.
• GTD - A Good Till Days/Date (GTD) order allows the Trading
Member to specify the days/date up to which the order
should stay in the system. At the end of this period the order
will get flushed from the system
• Day Order: A day order is valid for the day on which it is
entered. If the order is not executed during the day, the
system cancels the order automatically at the end of the Day.
• Immediate or Cancel (IOC) Order: An IOC order allows the
user to buy or sell as soon as the order is released into the
system, as long as the price conditions are matched.

9
Price Conditions
• Market Price: Market orders have no price specified at the time
order is released into the system. For a Buy Market Order, the
system matches the Sell Limit Orders in the Order Book and for the
Sell Market Order; system matches the Buy Limit Orders.
• Limit Price: An order to buy a specified quantity of a security at or
below a specified price, or an order to sell it at or above the
specified price. This ensures that the participant never pays a worse
price than the limit price set.
• Stop loss: This order type allows the participant to release an order
into the system after the market price of the security reaches or
crosses a threshold price.

10
Market Orders
• If a Sell Market Order
of size 500 hits the
order book at this
instant, then, it will
cross with Limit
Orders of Bid Price
82.75.
Bid Size Bid Price Ask Price Ask Size
600 82.75 82.90 23
152 82.65 83.00 300
212 82.60 83.15 143
53 82.55 83.20 512
200 82.50 83.25 45
100 82.75 82.90 23
152 82.65 83.00 300
212 82.60 83.15 143
53 82.55 83.20 512
200 82.50 83.25 45

11
Limit Orders
• If a Buy Limit Order
of Price 82.75, size
100 is added to the
Order Book then
Order Book is
changed to the
following
600 82.75 82.90 23
152 82.65 83.00 300
212 82.60 83.15 143
53 82.55 83.20 512
200 82.50 83.25 45
700 82.75 82.9 23
152 82.65 83 300
212 82.6 83.15 143
53 82.55 83.2 512
200 82.5 83.25 45

12
Characterization of Execution Algorithms
Time Uncertain Time Certain
Price Certain
Price Uncertain
Market
Order
Limit
Order
Other
Execution
Algorithms

13
Empirical - Relative Price
• In Indian data, it is observed that most orders
arrive at best bid and ask
• Close to 95% of all new orders placed in the
exchange are within 5 ticks of the best bid
and ask
• This could be due to Order to Trade Ratio
regulations on Indian Exchanges.

14
The Relative Price Distribution in terms of
Ticks from Best Bid and Best Ask
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
-6 -5 -4 -3 -2 -1 1 2 3 4 5 6

15
Replace Transition Mechanism
ASK BID
100
95
91
97
Current Order
- 5 Ticks from the ASK
Current Order
- 2 Ticks from the ASK
This is (-3, 5)
Transition

16
Replacement Transitions
• What does a (-3,3) mean
• Replace to Trade from Order at (ASK – 3 Ticks) to
ASK.
• What does a (0,1) mean
• Replace at Best Bid to Best Bid itself
• What does (0,2) mean
• Replace from (ASK – 2 Ticks) to (ASK – 2 Ticks)
• What does (1,1) mean
• Replace from (ASK -1 Ticks) to (ASK – 2 Ticks)

17
Replacement Matrix
1 2 3 4 5 6 7 8 9
-5 0.019 0.012 0.009 0.008 0.007
-4 0.012 0.021 0.024 0.030 0.016 0.013
-3 0.018 0.024 0.004 0.006 0.003 0.003 0.001
-2 0.014 0.022 0.006 0.039 0.039 0.041 0.009 0.006
-1 0.008 0.026 0.004 0.031 0.003 0.028 0.023 0.021 0.009
0 0.002 0.004 0.033 0.031 0.008
1 0.039 0.037 0.029 0.006
2 0.030 0.026
3 0.014
4 0.012
5
6
7
8
9
10
ReplaceTicks
Ticks from ASK

18
Volumes Shares
Order Ratios
Colo Non-Colo
Trade Ratios
Colo Non-Colo

19
Developments at National Stock Exchange
• Broadcast
• TCP Tick by Tick
• Multicast Tick by Tick
• Trade Execution Ranges

20
• Movement to New Exchange Technology
• Trades at 200 microseconds
• EMDI/EOBI Tick by Tick Streams
• Direct FIX connectivity (earlier IML Technology)
• Self Trade Prevention Checks
Developments at National Stock Exchange

21
Vicious Cycle
More
Volumes
Lower Costs
More
Opportunities
Higher volumes lead to gains in efficiency through the use of technology,
leading to lower transaction costs. Technology
is the enabler of the virtuous cycle, but cost is the driver.
As costs approach zero, volumes will peak as a result.

22
Statistical Arbitrage
Reliance
Futures
Reliance
Put/Call
Sensex
Put/Call
Sensex
Futures
Reliance
Stock
Statistical correlations arise because securities are driven by systematic factors
such as inflation, regulatory policies, currency prices, economic growth, and so on.
Because there are far fewer systematic drivers than there are securities which
depend on them, correlation between securities is guaranteed to exist!

23
Structural vs. Statistical Correlations
 Structural correlations tend to be
strong, steady, & robust
 Profitable opportunities tend to be
very easy to identify, and are thus
heavily competed for.
 Competition prevents structural
price divergences from growing
large – Small bets
 Tremendous speed is required in
order to access them before
competitors
 Mainstay of HFTs, who specialize in
fast trading
 Statistical correlations tend to be
weak, time-varying, and non-
stationary
 Profitable opportunities based on
statistical correlations tend to be
harder to model, and more
persistent in terms of their
duration
 Size and duration of these
opportunities facilitates large bet-
sizes and overnight positioning
 Such opportunities tend to be
favoured by large quantitative
hedge funds specializing in
statistical analysis

24
Introduction of New Instruments
• ETFs
• Interest Rate Futures
• VIX Futures
• Strategy ETFs ??
• Bonds ??
• Credit Instruments

25
It's the Latency, Stupid
Well known and referenced article
“a network link with low bandwidth can be
made better with money, but network link
with bad latency cannot be helped”
This was the scene in 1996, when bandwidth
was the constraint. Speeds were in Kbps.
Cheshire later become Wizard at Apple. Pioneering Zeroconf
http://rescomp.stanford.edu/~cheshire/rants/Latency.html

26
Misnomer – Bad Terminology
Would you say that a Boeing 747 is three times "faster" than a Boeing
737? Of course not. They both cruise at around 500 miles per hour.
The difference is that the 747 carries 500 passengers where as the
737 only carries 150. The Boeing 747 is three times bigger than the
Boeing 737, not faster.
Now, if you wanted to go from New York to London, the Boeing 747 is
not going to get you there three times faster. It will take just as long as
the 737.
In fact, if you were really in a hurry to get to London quickly, you'd
take Concorde, which cruises around 1350 miles per hour. It only
seats 100 passengers though, so it's actually the smallest of the three.
Size and speed are not the same thing.
On the other hand, If you had to transport 1500 people and you only
had one aeroplane to do it, the 747 could do it in three trips where
the 737 would take ten, so you might say the Boeing 747 can
transport large numbers of people three times faster than a Boeing
737, but you would never say that a Boeing 747 is three times faster
than a Boeing 737.

27
System Architecture of an Automated Trading System
• With the advent of DMA & automated trading, the
following changes in architecture took place:
– Latency between Event Occurrence & Order
Generation had to be reduced to an order of
milliseconds and lower.
– Order Management had to be made more robust to
handle generation of thousands of orders in a second
– Risk Management had to be done in real time and
without human intervention

28
Introduction to low latency
• Technology – State of Art
• Approach to latency improvement
• Latest in Low Latency -approaches and
technologies being deployed to achieve low
latency

29
Why aim for Low Latency or Lowest ?
• It may be necessary to lower latency just to remain competitive
• The strategy demands low latency, perhaps.
• It may be desirable to improve latency to stop getting picked off by
competitors
• With introduction of Colocations and increasing focus in remaining
fastest in the market, significant capital is invested. However it can all go
waste, if correct technology is not identified and implemented.
• The issue is that latency is difficult to quantify. As a result the value of
latency improvement, though easily understood, is extremely difficult to
quantify
• Lower latency systems cost a lot more to build and deploy. Hence the
objective should be to find the right balance between investment and
return on investment in low latency

30
Latencies – Strategy wise
Citihub, 2009

31
Latency by Distance

32
Microbursts

33
Corvil Analysis
“For this feed, how much bandwidth is needed to protect
99.99% of packets from loss with no more than 100
microseconds of latency to be experienced during the busy 1
second of the trading day”

34
Latency Recommendations

35
Technology Mix

36
Tips
• Servers – Fastest Cores, Cache,
• Operating Systems – RT kernels
• Fastest Network Infra (Switches, Routers )
• Retune the TCP stack
• Program Runtime – isolcpus, stack bypass
• Solid State Drives
• Latency Tuning – TCP_NODELAY, sendfile(2),
Lock Free Codes

37
Sample Solution Path

38
Thank You!
To Learn Automated Trading
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Order book dynamics in high frequency trading

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