Chapter 6 - Order Execution and Limit Order Book

Abstract

So far, we have introduced the financial products (Chapter 2), their price formation and market value (Chapter 3), building trading strategies (Chapter 4), and developing a risk management strategy (Chapter 5). In this chapter, we discuss the execution of the orders to buy and sell assets. In backtesting, we assumed that we can buy and sell any asset for any number of units (even fractional) at any price. In this section, we revisit the problem of market impact and implementation shortfall, the effect of our orders on the market price of an asset. We discuss commonly used execution strategies that naturally lead us to the very fundamental concept of limit order book (LOB) in the market microstructure. We explain limit order and market order types, how they interact with and evolve the LOB of an asset. Then, we overview research on LOB models. We get knowledgeable with the inner workings of the market microstructure, then, we discuss the reasons behind the Epps effect, diminishing cross-correlations between asset returns when the sampling (trading) frequency gets higher and higher. Finally, we discuss the category of high frequency trading (HFT). We review well known HFT strategies, and discuss the rich literature on covariance estimation with the high frequency market data. We finish the chapter by summarizing the low-latency (ultra high frequency) trading and highlighting the impact of HFT on the financial markets.