1st Year Report

Order Submission Strategy
and Computational Models of Limit-Order Execution
Chaiyakorn Yingsaeree
October 23, 2008

Abstract
Most equity and derivative exchanges around the world are nowadays organized as order-driven
markets where traders execute their trades by submitting either market orders or limit orders. A
market order provides an immediate execution at the best price available in a limit order book
upon the order arrival. With a limit order, a trader can improve his execution price relative
to the market order price but the execution is neither immediate nor certain. Determining an
appropriate order type of a particular trade is ultimately a fundamental problem faced everyday
by all investors in such markets, and a prerequisite for any approach for making such decision is a
model of limit order execution times and the associated execution probability. However, research
into how to model such probability is very limited, and primarily focused on the probability that
a newly submitted order will be executed in a specified period of time. In addition, these models
may not be appropriate to develop a dynamic trading strategy since only information about newly
submitted order can be inferred from those models.
The objective of this research is to develop a computational model of limit-order executions
in an order driven market that can be used to predict the probability that a giving limit order
will be executed in a specified period of time as well as investigate the optimal way to utilize the
developed model to make order placement and trading decision in algorithmic trading systems.
Unlike traditional models that focus on only newly submitted limit orders, we focus on modeling
the execution probability of all orders in the order book with the aim to gain more insight on the
determinants of the execution probability and how this probability change over time. The insight
gained from this model is then utilized to solve order placement decision problem faced by an
investor as well as to derive optimal trading strategies for several decision problems in algorithmic
trading system.
During the first year of my study, I produced one review paper that presents the overview of
the emerging field of Computational Finance. I also designed a virtual hedge fund system and
supervised a group of MSc student to develop it. For the works related to my research, I developed
a program to collect real time order book information from Reuters data feed as well as developed
a program to calculate the empirical distribution of execution probability from trade information.
The future work includes developing simulation model of order driven markets to generate data
for control experiments, developing new probability model of limit-order execution by utilizing
non-parametric techniques from machine learning community (e.g. Bayesian neural network and
relevance vector machine), developing a platform to develop an automated trading system, and
developing an order submission strategy that utilizes the developed execution probability model.
This work is in collaboration with Deutsch Bank, and I expected to spend a period of internship
at Deutsch Bank to test the developed model with the real environments.
1
Contents
1 Introduction 4
1.1 Motivations from the literature and industry . . . . . . . . . . . . . . . . . . . . . 4
1.2 Objectives of this research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3 Outline of this report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2 Background 8
2.1 Market architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.1 Limit order markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.2 Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1.3 Auctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 The limit order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3 Algorithmic trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.4 Trade execution strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4.1 Choice of trading venue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4.2 Choice of trade schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.4.3 Choice of order type . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3 Literature Review 16
3.1 Order submission strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.1.1 Static order submission strategies . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.2 Dynamic order submission strategies . . . . . . . . . . . . . . . . . . . . . . 20
3.1.3 Framework for order submission strategy . . . . . . . . . . . . . . . . . . . 21
3.2 Limit-order execution models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2.1 Execution probability models . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.2.2 Execution time models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4 Research Proposal 31
4.1 Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.2 Problem statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.3 Expected contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.4 Scope of the research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.5 Validation of contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
2
CONTENTS 3
5 Research Plan 33
5.1 Tools for real-time data collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.2 Simulation models of pure limit order book markets . . . . . . . . . . . . . . . . . 34
5.3 Platform for algorithmic trading system development . . . . . . . . . . . . . . . . . 34
5.4 Computational model of limit-order execution . . . . . . . . . . . . . . . . . . . . . 35
5.5 Order submission strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.6 Timetable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
6 Work to Date 37
6.1 Banking science virtual trading platform . . . . . . . . . . . . . . . . . . . . . . . . 37
6.2 Empirical distribution of execution probability . . . . . . . . . . . . . . . . . . . . 38
Chapter 1
Introduction
Advances in telecommunication and computing technologies during the past decades have created
a trend toward the automation of financial markets which are now becoming increasingly global,
dynamic and, thus, complex. As a result, it has become essential for their participants to have the
most innovative technology in order to deliver critical solutions and improve productivity so as to
enhance their profits and competitiveness. The advent of electronic trading venues together with
the ability to store a huge amount of data enables us to capture a detailed record of all events
occurring in the market. This detailed record are gradually becoming available to researches
and, thus, enables us to analyze the characteristic of the markets, such as intraday order flows
and imbalances in supply and demand, as well as the behaviors of their trader, such as trader’s
order submission strategy, as a function of contemporaneous and past states of the market. The
insights gained from these scientific investigations can then be applied to devise new ways of profit
making and reducing the cost of trading by optimizing the timing, size, and other characteristics
of submitted order.
1.1 Motivations from the literature and industry

Most equity and derivative exchanges around the world are nowadays organized as order-driven
markets where traders execute their trades by submitting either market orders or limit orders. A
market order is an order to buy/sell a pre-specified quantity of a financial instrument at the best
available price placed by previously submitted limit orders that make up a limit order book. In
contrast, a limit order is an order to buy/sell a pre-specified quantity of a financial instrument
at a specific price. Unexecuted limit orders are stored in the limit order book until they are
canceled or triggered by incoming market orders. Consequently, a trader in these markets need
to decide when to submit market orders and when to submit limit orders in order to obtain the
most favorable result.
The main differences between market orders and limit orders is the price at which the order is
executed and the probability of execution as well as the execution time. When market conditions
permit (i.e. enough liquidity), a market order provides immediate execution but the execution
price is not certain1 . On the other hand, a limit order guarantees the execution price, but the
1
The uncertainty of execution price is usually caused by rapid changes to the limit order book during a period
between order submission and trade execution. In an electronic market, multiple events can happen within a
4
CHAPTER 1. INTRODUCTION 5
order may sometimes be executed only partially or not at all. In addition, a trader who submits
limit orders may also offset by picking-off risk2 if he does not monitor the market continuously.
Moreover, if the submitted limit order is not executed, the trader must decide when, and how, to
resubmit the order. Thus, determining an appropriate order submission strategy for a particular
trade is ultimately a fundamental problem faced everyday by all traders participating in such
markets, and the solution to this problem is of paramount significance not only to all traders,
particularly to institutional investors who frequently trade large volumes of shares representing
a quarter or more of the whole market volume, but also to market microstructure literature that
analyze the rational for, and the profitability of, limit order trading as well as the characteristics
and dynamic behaviors of the limit order market. In addition, a methodology to solve such
problem can also be utilized as a building block to solve many decision problems in algorithmic
trading literature.
The desire to understand traders’ order submission strategies has inspired a wide range of
theoretical and empirical research. On the theoretical side, many order submission models have
been proposed and examined to analyze the rational for, and the profitability of, limit order
trading as well as the characteristics and the dynamic behaviors, of the limit order market (e.g.
[11, 22, 39, 16, 21, 17]). Empirical approaches, on the other hand, analyze history of trades and
quotes that occur in the exchange to achieve the same goals. Although recent empirical studies
[7, 19, 41, 44, 6, 33, 20, 18, 10, 34] indicate that trader’s decision of when and which order type
to submit is significantly influenced by the state of the order book (e.g. the queue volume, the
market depth, and the inside spread) as well as its dynamic (i.e. recent changes to the order
book), little attention has been paid to develop an order submission strategy that utilizes this
information to optimize trade execution. Notable exceptions are Nevmyvaka et al. [37, 36] who
propose a quantitative method that allows traders to optimally price their limit orders with the
aim to minimize trading costs based on the state of the order book.
While their results indicate that incorporating market conditions into the decision can greatly
improve the execution result, their works are loosely related to traditional models since they utilize
reinforcement learning to directly optimize order execution without any consideration about the
tradeoff suggested by theoretical order submission models. As a result, the main drawback of their
approach is that, when traders’ trading objectives change, new reinforcement learning models have
to be constructed and trained to obtain an appropriate strategy. To avoid this inconvenience,
it might be better to incorporate information about market conditions into traditional order
submission models so that, after the model is calibrated, traders can utilize the model regardless
of their objectives.
Although traders’ order submission decisions can be explained by several factors, theoretical
models generally view these decisions as a tradeoff between the expected profit and the free-
trading option. The expected profit depends on the execution price and the execution probability
of a limit order, while the value of free trading depends on the arrival probability of adverse
information which may move the price through the submitted limit order. Undoubtedly, one of
millisecond, and our execution price may be affected by the submission of market orders from competing traders
as well the revision of the price and volume at the best quote.
2
Picking-off risk, also known as adverse selection cost and winner’s curse problem, is associated with the well-
known concept that limit orders are free options to other traders [12] and these options will become mispriced
as soon as the fundamental of the instrument is changed. Hence, traders who submit limit orders may expose
potentially large losses if they do not constantly update their orders to reflect these changes.
the most important factors in valuing such tradeoff is a model of limit order execution times and
the associated execution probability [11, 39, 16, 21, 42, 1, 26]. The main reason for this is that
the expected profit of traders who decide to trade via limit orders is an increasing function of the
execution probability. The larger the execution probability, the shorter the expected waiting time,
and thus the smaller the expected adverse selection cost. In addition, recent empirical findings
indicate that there is a strong relationship between this probability and the state of the order
book. In particular, Omura et al. [38] report that the probability of execution of limit orders
on Tokyo Stock Exchange (TSE) is lower when there are open ticks between the bid-ask spread
and when the depth, the quantities of limit orders at the best price, of the same side is high.
Conversely, the execution probability is higher when the depth of the opposite side of the book
is high. This is in accordance with Biais et al. [7] who indicate that, for the Paris Bourse CAC
system, order flow is concentrated near the best quotes with depth somewhat larger at nearby
quotes. When depth at the best quote is large, traders rapidly place limit orders within the
spread, while traders place market orders when the spread is small. All of these suggest that it is
sensible to model the execution probability of limit orders using the state of the order book and
utilize this model to derive the optimal order submission strategy. However, to the best of our
knowledge, no research effort on this topic has been reported in the literature before.
1.2 Objectives of this research

The main objective of this research is to develop a computational model of limit-order executions
in an order driven market that can be used to predict the probability that a giving limit order
will be executed in a specified period of time as well as to investigate the best way to utilize the
developed model to make order submission and trading decision in algorithmic trading systems.
Unlike traditional models of limit-order execution that mainly focused on modeling the prob-
ability that a newly submitted limit order will be executed in a specified period of time, this
research focus on modeling the execution probability of all orders in the order book with the aim
to gain more insight on the determinants of the execution probability and how this probability
changes over time. The inspiration behind this approach is that, when time goes by, the position
of a limit order in the limit order book will change and its execution probability should also change
accordingly. Although traditional models can be utilized to determine the execution probability
of a newly submitted limit order, they have no information about how this probability is changing
over time since they model only newly submitted orders. Consequently, this limitation suggests
us to construct an execution probability model of all orders in the limit order book so that the
resulted model can be utilized to analyze the dynamic of this probability.
Another focus of this research is on the trade implementation problem faced by traders who
want to transact a financial instrument in an order driven market. Specifically, the problem these
traders face is whether to trade aggressively by submitting a market order or trade patiently by
placing a limit order as well as how to dynamically update this decision based on the changing
market condition in order to obtain the most applicable result. Although recent empirical re-
searches indicate that this decision is significantly influenced by the state of the order book and
its dynamics, little attention has been paid to develop an order submission model that utilizes
these information to optimize trade execution. To fill the gap in the literature, we are interested
in extending traditional order submission models to utilize this information. Particularly, we want
to model the execution probability of limit orders using this information and utilize this model
to derive the optimal order submission strategy for several trading problems faced in algorithmic
trading systems.
1.3 Outline of this report

The outline of this report is as follows. In chapter 2, the background information on a number
of key concepts in the areas that this research spans will be reviewed in detail to give the reader
a clear view of the problems and environments studied in this research. The literature review of
related topic will be discussed in chapter 3. In chapter 4, the scope and objectives of this research
will be presented. Finally, research plan for achieving those objectives will be described in section
5.
Chapter 2
Background
This chapter presents background information on a number of key concepts in the areas that
this research spans. Particularly, the information about trading mechanisms frequently used in
financial markets is presented with the main emphasis on the limit order book markets which is
the main market studied in this research. The broad area of algorithmic trading is also reviewed
to place our work in a well defined context and to outline a rich picture of business reality for
which the extended version of this research could be considered in the future work.
2.1 Market architecture

A financial market is a place where firms and individuals enter into contracts to buy or sell financial
instruments such as stocks, bonds, options and futures. It basically provides forums where traders
meet to arrange trades according to some predefined rules that govern its trading mechanism.
During the last decades, financial markets have evolved significantly from traditional floor markets
where traders come in contact and agree on a price physically on the floor of an exchange to
electronic markets where traders’ orders are submitted, via a computerized screen-based system,
to a central order book, and trades are created according to a specific matching algorithm. As a
result, despite of their original mechanisms, most financial markets nowadays are actually hybrids,
involving limit order book and other trading mechanisms including dealers, clearing, and auctions.
This section briefly describes the main properties of each trading mechanism. Note that the detail
presented in this section are summarized from reference [25], and thus more thorough information
on the topic can be obtained from it.
2.1.1 Limit order markets

Most financial markets have at least one electronic limit order book. A limit order is an order
to buy a specific quantity of a financial instrument at no more (or sell at no less) than a specific
price. In a limit order market, orders arrive randomly in time. The limit price of a newly arrived
order is compared to the orders that are already stored in the system to determine whether
there is a match or not. If there is a match, the trade will occur at the price set by the order
previously stored in the system. The sequence in which these orders are executed is governed by
some specific priority rules. Price normally is the highest priority, and a buy (sell) order with
the highest (lowest) limit price will has the highest trading priority. Time rule which states that,
8
CHAPTER 2. BACKGROUND 9
if two orders have the same limit price, the one which was entered into the system first will has
the priority usually has second priority. Other priorities such as order quantity are also used in
some markets (e.g. LIFFE). A list of unexecuted limit orders stored in the system constitutes a
limit order book. Since limit orders can be modified or canceled at any time, the order book is
dynamic and sometimes it can change rapidly especially in active markets.
Instead of using limit orders, a trader may desire that an order must be executed at the
market, i.e., at the best available price. To achieve this, the trader can submit a market order, an
unpriced order which will be executed immediately against the best order, to the market. If the
order quantity is larger than the quantity available at the single best price on the book, the order
will walk the book resulting in partial executions at progressively worse prices until the order is
fully filled.
A market might have multiple limit order books, each managed by different broker. Limit
order books might also be used in conjunction with other mechanisms. When all trading occurred
through a single book, the market is said to be organized as a consolidated limit order book
(CLOB) which is used for actively traded stocks in most Asian and European markets.
2.1.2 Dealers
Dealer markets
A dealer is basically an intermediary who is willing to act as a counterparty for the trades of his
customers. A trade in a dealer market, such as FX market, usually starts with a customer calling
a dealer to ask for its price quotes (i.e. the dealer’s bid and ask price), and, then, the customer
may buy at the dealer’s ask, sell at the dealer’s bid, or do nothing. Unlike limit order markets
where a buyer who thinks the best price in the book is unreasonable can place his or her own
bid, a buyer in dealer markets does not have a possibility to do that. Dealer markets are also
usually characterized by low transparency since dealers usually provide quotes only in response
to customer inquiries and these are not publicly visible.
In addition to dealer-customer interactions, interdealer trading is also important for conducting
dealer business. Since the incoming buy and sell orders that a particular dealer sees are usually
imbalanced, accommodating these customer needs may leave the dealer with an undesired long
or short position. In such case, the dealer may attempt to sell or buy in the interdealer market
to balance its position. Nowadays, some of these interdealer markets, FX market, are conducted
via a limit order book, such as Electronic Broking Services (EBS) and Reuters Dealing 3000 Spot
Matching (D2).
Dealers in hybrid markets

Dealers can make markets work where they might otherwise fail. For example, a limit order market
where customers directly trade against each other generally has difficulty with small stocks for
which trading interest in insufficient to sustain continuous trading. In such case, a dealer may
make continuous trading possible by actively supplying bids and offers. Although this may well
be occurring in actively traded securities, the potential dealer’s costs of continuously monitoring
bids and offers of low activity securities may be too large to recover from the relatively infrequent
traders. In these instances, continuous liquidity requires that a dealer be designated (by the
market authority) and provided with additional incentives. The best-known designated dealer is
possibly the NYSE specialist who has many roles and responsibilities but an important one is to
maintain a two-sided market when there is nothing on the limit order book and on one else on
the floor bidding or offering.
With the advent of electronic order management system, the competitive position of dealers
and other intermediaries has weakened since, nowadays, customers can update and revise their
limit orders rapidly enough to respond to market conditions. Hence, they can quickly supply
liquidity when it is profitable to do so and quickly withdraw their bids and offers when markets
are volatile. As a result, the presence of a dealer to maintain a two-sided market is considerably
diminished from most of financial markets. However, dealers today serve another useful function
in facilitating large (block) trades especially in the block market, also called the upstairs market.
When an institution contact a dealer to fill a large order, the dealer can act as a counterparty, try to
locate a counterparty for the full amount, work the order over time, or some combination of these.
The dealer’s advantage here thus lies in access to capital, knowledge of potential counterparties,
and expertise in executing large order overtimes, also known algorithmic systems.
2.1.3 Auctions
When multiple buyers and sellers are concentrated in one venue at one time, trades may not need
to be coordinated since agents can contact each other sequentially to strike bilateral bargains.
However, the result obtained from such approaches may not be economically efficient since many
participants will execute their trades at prices worse than the best price realized over the entire
set of trades. To avoid this problem, a single-price clearing, which is generally implemented with
a single-price double-sided auction should, could be employed. In this mechanism, supply and
demand curves are constructed by ranking bids and offers from all participants, and the clearing
price is usually determined by maximizing the feasible trading volume. The double-sided auction
is widely used in security markets especially for low activity securities. The Euronext markets, for
instance, conduct auctions once or twice per day depending on the level of interest. Double-side
auctions are also usually used to open continuous trading sessions (e.g. Euronext, Tokyo Stock
Exchange, and NYSE) and, also, at the close of continuous trading sessions.
Although most auctions in secondary markets are double-sided, single-sided auctions are
widely used in primary markets. These include the U.S. Treasury debt markets, and most U.S.
municipal bond offerings. They are also used, though not as often, for initial issues of equity.
In summary, financial markets have various architectures. Some of the main characteristics distin-
guish them are presence or lack of intermediation and continuous or periodic trading. Intermedi-
ated markets employ market markers, dealers, or specialist, who determine price quotes and act as
a counterparty in each trade. Consequently, these markets are usually referred to as quote-driven
markets due to the quote setting function of the dealers. In non-intermediated markets, trading
does not involve intermediates but submitted orders are stored, matched, and executed via the
limit order book. These markets are usually referred to as order-driven markets since the whole
trading process is determined by submitted orders. The second characteristic determines if trades
are executed continuously during a trading session or only at certain points in time. These two
modes are called a continuous double auction and a periodic auction respectively.
2.2 The limit order book

Since the main objective of this research is to develop a limit-order execution model of a pure limit
order market, this section further describes the main principles of the continuous double auction
and the call auction in the order-driven market. A comprehensive description of order-driven
market can be found in reference [23] and [25].
As discussed the previous section, the limit order book is a mechanism for collecting, storing,
and matching of buy and sell limit orders submitted by market participants. It is a mechanism
which is used for actively traded stocks in most Asian and European markets (e.g. the Australian
Stock Exchange, the Paris Bourse, the Tokyo Stock Exchange and the Singapore Stock Exchange).
In these markets, a trader can execute his or her trades by submitting either market orders or
limit orders. If the trader submits a limit order, the limit price of a new order will be compared to
the orders stored in the system to determine whether there is a match or not. A list of unexecuted
limit orders stored in the system constitutes a limit order book, and these orders will be stored
in the book until they are amended, deleted or traded. If the trader submits a market order, the
order will be immediately executed against the best order available in the order book. Thus, the
order book is the most important component of these markets.
The limit order book normally consists of two queues, called a buy (bid) and a sell (ask) side,
which store buy and sell limit orders respectively. Buy orders are called bids, while sell orders
are called asks (offers). A bid in the order book with the highest limit price is called the best
bid, while an ask with the lowest limit price is called the best ask. The price differences between
the best ask and the best bid is called the spread. When the spread is positive, the price in the
middle of the spread, equal to an average of the best ask price and the best bid price, is defined
and called the mid price. The quantities of limit orders at the best prices are sometimes called the
depths of the market. Bids and asks are entered into the book by market participants throughout
a trading day, with prices and sizes of their choice. Thus, the book is dynamic and sometimes it
can change rapidly especially in active markets.
Trading in limit order markets can take place continuously or at specific points in time. The
former is called a continuous double auction, while the latter is a call auction. In continuous
auction, a trade takes place whenever a new bid (ask) arrives with a limit price equal to or higher
(lower) than the limit price of the best ask (bid) in the limit order book. Such an order, called
a marketable limit order, creates an overlap between the prices of the best bid and the best ask,
thereby changing the spread from positive to zero or negative. The non-positive spread triggers
the order matching mechanism which will execute a trade at a price equal to the limit price of an
existing order in the book. In a call auction, limit order are stored in the book regardless of the
value of the spread, and the order matching mechanism is activated at a specific point in time to
match orders in the book and generate trades at a single price. The single market clearing price
is determined in a way that maximizes the traded volume, and results in the execution of bids
(asks) with the same or higher (lower) limit price. A trade in a continuous auction can also be
triggered when a trader submits a market order. The market order is an unpriced order which
is executed immediately against the best order. If the order quantity is larger than the quantity
available at the best price on the book, the order will walk the book resulting in partial executions
at progressively worse prices until the order is fully filled. On some exchanges, however, market
orders are implemented via limit orders priced for immediate execution, and known as marketable
limit orders.
2.3 Algorithmic trading

As financial market becomes more competitive, financial institutions and investors have started to
turn to automated trading, the computerization execution of financial instruments following some
specified rules and guidelines, to gain competitive advantage. With the ability to communicate
electronically with exchanges and other electronic trading venues, it is now possible to construct
automated trading systems to analyze the changing market data and place orders when certain
criteria are met. These systems can be customized to execute almost any trading strategy. Some
aim to detect fleeting price anomalies and arbitrage opportunities in order to take a position
and make profit when such situations occur. Others slice up a large trade into smaller trades
to manage market impact and timing risk as well as to mask intentions and prevent rivals from
squeezing the trader on price. This section presents an overview of this fast growing area by
presenting its definition together with some aspects concerning the development of such system.
Although there are a variety of algorithm trading systems, from now on will be referred to as
AT, commonly used within the financial industry, these systems might generally be described as
trading with some of its processes being performed by an algorithm running on a computer with
little or no human intervention. The trading process could be roughly separated into three main
steps: trading signal generation, trading decision, and trade execution. The signal generation
usually involves the analysis of changing market information to detect the trading opportunities
within the market, and the result is a trading signal indicating when to buy and when to sell
a particular financial instrument. The generated trading signals are then analyze, usually by
human, to confirm the trading decision in the second step. After the trading decision is finalize,
the last step is to execute the trading decision by sending the corresponding order to financial
markets. Although this simplified description of the trading process may not be hold for some
traders (e.g. the market makers) in some financial markets, it illustrates that the trading process
can be divided into different steps each of which can be separately programmed and executed
by an algorithm running on a computer system. According to this simplify trading process,
algorithmic trading system might be categorized into four main types, as described by Idvall and
Jonsson [28], which are:
• The systems that automate the first step of the trading process, namely the trading signal
generation. Thus, human intervention is required for the last two tasks of the trading
process, which are the trading decision and the execution of the trade.
• The systems that automate the trade execution which is last step of the trading process.
The aim of the execution algorithm is often focuses on placing and managing orders in the
market in order to minimize the trading cost. Using execution algorithms leaves the first
two steps to the human trader.
• The systems that combine the first two categories but leaving the trading decision to the
human trader.
• The fully automated systems, often referred to as black-box trading, that automate all steps
in the trading process.
Hence, most algorithmic trading systems consist of two main parts: determining when to trade
and how to trade. Determining when to trade is the analytic part of the strategy which revolves
around watching the changing market data and detecting opportunities within the market. For
example, consider a pair trading strategy that examines pairs of financial instruments that are
known to be statistically correlated. Normally statistically correlated instruments are likely to
move together. When these instruments break correlation, the trader may buy on and sell the
other at premium with the hope to gain profit when both instruments become correlated again. In
this case, the algorithm involves monitoring for any changes in the price of both instruments and
then recalculating various analytics to detect a break in correlation. Another example is market
making strategy which tries to place a limit order to sell above the current market price or buy
a limit order below the current price in order to benefit from the bid-ask spread. In addition,
any sort of pattern recognition or predictive model can also be used to initiate the trade. Neural
networks and genetic programming have been extensively used to create these models.
Determining how to trade focuses on placing and managing orders in the market. At the lowest
level, this involves with determining the suitable choice of order type (i.e. limit and market order)
for each trade. This choice is no simple matter and requires some sophistications since market
orders are executed immediately but incur substantial price impact while limit orders incur no
price impact but may not be executed immediately, if at all. A higher level problem involves
with breaking up a large order into smaller orders and placing them into the market over time.
The benefit of this is that large orders have a major impact in moving the market while smaller
orders are more likely to flow under the market’s radar, and subsequently have less impact to the
market. In addition, when an interested instrument is traded in multiple exchanges, an execution
strategy also needs to determine where the order should be submitted to. Since this research is
more related to this issue, more detailed information about it will be discussed in the next section.
2.4 Trade execution strategies

An investor, or an algorithmic trading system, who wants to buy or sell shares of a particular
financial instrument faces a number of choices. After the trading decision have been finalized
(i.e. the financial instruments for buying and selling have already been picked), the main problem
to be solved is trade execution with constraints on transaction costs and trading duration. To
execute the trade, an order has to be submitted to a trading venue with the choice depends on the
selected financial instrument, order size, hours of operation and other factors. If an order requires
a small number of shares, comparing to the available liquidity, it can be executed by a submission
of a single market order. Alternatively, if the number of shares required is larger than what is
available in the market, an order may be broken up into a sequence of smaller orders which will
be submitted to the market over a specific period of time. In addition, a trader also needs to
decide a preferred order type. If the trader is patient, he may choose to submit a limit order to
obtain price improvement. On the other hand, an information motivated trader may choose to
submit a market order to achieve an immediate execution. The following sections briefly discuss
these three problems. More detailed information can be found in reference [8] from which the
detail presented in this section is summarized.
2.4.1 Choice of trading venue

Some financial instruments may be traded on more than one financial market. To execute a trade
for these instruments, a trader needs to determine the market the order has to be submitted to.
Normally, the trader may want to submit the order to the market whose characteristics suit his
requirements most. Some of the most important characteristics the trader usually considers are
liquidity, trading mechanism and degree of trader’s anonymity.
A financial instrument in a particular market is considered liquid if the volume of trades and
orders of that instrument is large. Liquidity is important because high liquid market is usually
associated with fast trade execution and low transaction costs. Thus, all other things being equal,
the trader would prefer to submit his orders to the market with the most liquidity.
A trading mechanism employed in the market is also an important characteristic the trader
usually considers before making trade execution decision since each mechanism has it own ad-
vantages and disadvantages. As discussed in section 2.1, trades in a continuous double auction
market are executed continuously during a trading session, while trades in a periodic auction are
executed only at certain points in time. As a result, it is more appropriate to trade in a continuous
double auction market when immediacy is required. However, trades in the periodic auction have
lower price volatility when compares to trades in the continuous double auction [13].
In the case that trader’s order is too large to be executed instantaneously without an unwanted
price impact, the trader’s action will be influenced by his trading motivation. If trading is infor-
mation motivated, it might be more appropriate to carry out in a market that offers anonymity.
In addition, trader may also break up the large order into a sequence of smaller orders and submit
them to the market over a period of time with the aim to reduce price impact by hiding from
other participants the fact that all those orders were originated by the same trader. On the other
hand, a liquidity-motivated trader whose motivation is not information related is not necessary
to do that and may submit his order to an upstairs market directly.
2.4.2 Choice of trade schedule

As previously discussed, a price impact of a single market order for a particular financial instru-
ment will be minimal if the order size does not exceed the volume available at the best quote.
However, if the size of the order is too large to execute without an unwanted price impact, it would
be more efficient to break the order down into several smaller orders which are then submitted
into the market over a period of time. The benefit of this is that large orders have a major impact
in moving the market while smaller orders are more likely to flow under the market’s radar, and
subsequently have less impact to the market. Although smaller orders will have a lower price
impact, delayed execution may expose them to potential adverse price movements as well as an
opportunity cost. Thus, the problem of generating an optimal trade schedule which will achieve
a desired balance between price impact and opportunity cost is another important problem for
traders whose position is usually larger than the depth of the market.
During the last decades, there is a growing interest in developing model to solve such decision
problem (See [2, 9, 30, 3, 4] for example). The optimal trade schedule generated from these models
usually depends on several factors including a trader’s objective, market impact and the dynamics
of future market prices. Typically there are two main steps in specifying the trading objective.
The first step is to define execution cost by defining the specification of transactional cost and
choosing the desired benchmark price (e.g. previous close, opening price, arrival price, VWAP,
TWAP, and future close). The benchmark price is investor specific and depended on investment
objectives (e.g. a mutual fund may desire execution at the closing price to coincide with valuation
of the fund while an indexer may desire execution that achieves VWAP as an indication of fair
prices for the day). The second step is to specify the degree of risk-aversion (i.e. how much we
penalize variance relative to expected cost) which indicates the level of trading aggressiveness or
passiveness. Aggressive trading is associated with higher cost and less risk while passive trading
is associated with lower market impact and higher risk. Market impact, the degree to which an
order affects the market price, consists of permanent impact cost due to information leakage of
the order and temporary impact cost due to the liquidity and immediacy needs of the investor.
These market impacts are usually approximated by fitting some parametric functions (e.g. linear
and power laws function) using historical data. In addition, these functions can be both time
dependent and time independent. To specify the dynamics of future market prices, arithmetic
random walk is the most popular model. Giving specifications of all these factors, an optimal
trading strategy for a specific trading objective may be obtained by solving the corresponding
stochastic dynamic optimization problem.
2.4.3 Choice of order type

As discussion in section 2.1.1 and 2.2, there are two main order types that a trader can submit to
an order-driven market which are a market order and a limit order. A market order is an order
to buy/sell a pre-specified quantity of a financial instrument at the best available price placed by
previously submitted limit orders that make up a limit order book. In contrast, a limit order is an
order to buy/sell a pre-specified quantity of a financial instrument at a specific price. Unexecuted
limit orders are stored in the limit order book until they are canceled or triggered by incoming
market orders.
The main differences between market orders and limit orders is the price at which the order is
executed and the probability of execution. When market conditions permit (i.e. enough liquidity),
a market order provides immediate execution but the execution price is not certain1 . On the other
hand, a limit order guarantees the execution price, but the order may sometimes be executed only
partially or not at all. In addition, a trader who submits limit orders may also offset by picking-
off risk2 if he does not monitor the market continuously. Although, with limit orders, traders
can improve their execution price relative to market orders, this improvement is offset by the
risk of non-execution and adverse selection cost inherent in limit orders. Thus, to determine
an appropriate order submission strategy, traders have to find the right tradeoff between price
improvement, execution probability and adverse selection cost. Note that this decision problem
is the main focus of this research and more detail information about how to model it will be
presented in section 3.1.
1
The uncertainty of execution price is usually caused by rapid changes to the limit order book during a period
between order submission and trade execution. In an electronic market, multiple events can happen within a
millisecond, and our execution price may be affected by the submission of market orders from competing traders
as well the revision of the price and volume at the best quote.
2
Picking-off risk, also known as adverse selection cost and winner’s curse problem, is associated with the well-
known concept that limit orders are free options to other traders and these options will become mispriced as soon
as the fundamental of the instrument is changed. Hence, traders who submit limit orders may expose potentially
large losses if they do not constantly update their orders to reflect these changes.
Chapter 3
Literature Review
In this section, we present and analyze the current state of research of order submission strategies
and limit-order execution models. In section 3.1, the order submission problems frequently faced
by traders are presented and formalized. The existing techniques for solving those problems are
also presented in this section. The method for modeling the execution probability, which is one of
the most important information to make order submission decision, are presented in section 3.2.
Finally, our conclusion remarks about the existing techniques and the way to improve them are
given in section 3.3.
3.1 Order submission strategies

Consider a trader, or an algorithmic trading system, who want to trade small orders of some
financial instruments so that it is not necessary to break his order into smaller one to manage
market impact cost. The decision this trader face is when to submit market orders and when to
submit limit orders in order to obtain the most favorable result. In addition, if his order is not
executed, he must decide when, and how, to resubmit his order.
As discussed in section 2.1.1 and 2.2, the main differences between market orders and limit
orders is the price at which the order is executed and the probability of execution (as well as the
execution time). When the market has enough liquidity, which we can assume to be the case, a
market order provides immediate execution, but the execution price is not certain. On the other
hand, a limit order guarantees the execution price, but the order may sometimes be executed only
partially or not at all. In addition, if the trader does not monitor the market continuously, his
order may fill when the underlying value of the asset moved against him.
Traditionally, the decision whether to submit a market order or to submit a limit order is
usually examined in the context of the tradeoff between the payoff associated with limit orders
and the risk of non execution [11, 39, 16, 27, 31]. On one hand, traders would prefer to place their
orders very far from the best bid/ask price because this will increase their payoff. On the other
hand, the larger the distance from the best price the larger the chance that the order will not be
executed. Thus, in this setting, traders have to find the right tradeoff between these two opposite
choices in order to maximize the expected profit obtained from the trade. Undoubtedly, one of
the most important factors in valuing such tradeoff is a model of limit order execution times and
the associated execution probability [11, 39, 16, 21, 42, 1, 26] since the expected profit of traders
16
CHAPTER 3. LITERATURE REVIEW 17
who decide to trade via limit orders is an increasing function of the execution probability.
In reality, an order submission strategy that a trader selects normally depends on the trading
problem he tries to solve. As suggested by Harris [24], three main trading problems frequently
faced by traders are: (i) the liquidity trader problem considering how a liquidity trader who must
fill his order before some deadlines should trade, (ii) the informed trader problem considering
how an informed trader who receives a single signal about asset value should trade before his
information becomes obsolete and (iii) the value-motivated trader problem considering how a
trader who continuously estimates security value should trade. Specifically, liquidity traders must
fill their order before some deadlines which may arise when they need to invest or disinvest their
cash flow. The main objective of these traders is to obtain the best price for their trades by
carefully choosing their order submission strategies. On the other hand, informed traders, who
have private information about the underlying value of the asset, want to profitably trade on
their information. Although informed traders do have a trading deadline, which is the time
their information becomes obsolete, they did not have to fill their orders before the deadline like
liquidity traders. In fact, informed traders will trade only when it is profitably to do so. Like
informed traders, value-motivated traders also have private information about the values of asset.
However, unlike informed traders, they do not have a specific deadline and are assumed to trade
repeatedly in the market since they receive continuous information about the values.
Order submission strategies previously proposed in the literature can be classified into two
main categories: static strategies and dynamic strategies. Static order submission strategies view
this problem as a one-shot game where traders can make their order decision only once. If they
decide to submit a limit order, no additional change can be made to the order and it will stay
in the order book until it is executed or the end of the trading period is reached. Conversely,
dynamic order submission strategies allow traders to cancel or make changes to their orders before
the order expires or is executed [24, 43]. Empirically, traders change their order submission as
market conditions change. They continuously monitor the market and make appropriate changes
to their orders whenever necessary. For example, to reduce the execution risk, they may convert
their limit order to market order when the demand for immediacy increases. They may also
reprice or cancel their limit orders when the underlying value of the asset changes to manage
the adverse selection cost. Hence, it is more appropriate to model this decision with dynamic
strategies than with static strategies.
This section briefly describes related work in order submission strategy. Static order submis-
sion strategies are presented in section 3.1.1, while dynamic strategies are discussed in section
3.1.2. A general framework that can be utilized to describe theoretical order submission strate-
gies will be described in section 3.1.3. The overview of all models discussed in this section is
summarized in table 3.1.
3.1.1 Static order submission strategies

As previously discussed, static order submission models consider the decision whether to submit
a market order or to submit a limit order as a one-shot game where a trader can make their order
decision only once. If the trader decides to submit a limit order, no additional change can be made
to his order and it will stay in the order book until it is executed or the end of the trading period
is reached. This formulation can be utilized to solve the problems of both liquidity traders [22, 37]
and informed traders [11, 39, 16, 27, 17, 31]. The main difference between these two problems is
Problem Type Strategy

Models Incoporated Variables
I II III Static Dynamic
Handa and Schwartz [22] x x -
Parlour [39] x x volume in the book
Foucault [16] x x volatility
Hollifield et al. [27] x x volatility, order quantity, volume at bid/ask,
trading volume, time of day
Foucault et al. [17] x x order arrival rate, spread
Nevmyvaka et al. [37] x x order quantity, time of day, trading volume
Lillo [31] x x volatility
Cohen et al. [11] x x -
Harris [24] x x x x volatility
Nevmyvaka et al. [36] x x order quantity, spread, order imbalance,
immediate cost, trading volume
Wang and Zhang [45] x x order quantity, order imbalance
Slive [43] x x volatility, spread
Table 3.1: Overview of order submission strategies reviewed in this section. Each model is char-
acterized by the trading problem it tries to solve, whether it is static or dynamic strategy and the
market variables that it utilizes.
that liquidity traders have to fill their order before the deadline; thus, if liquidity traders decide
to submit a limit order and their orders are not executed, they have to submit market orders to
execute the trade when their deadlines are approached. On the other hand, informed traders will
submit market orders to fill the traders only when it is still profitably to do so.
Static strategies for liquidity traders

Consider the problem of liquidity traders who want to transact their orders before some specific
deadlines. Normally, they can choose to submit their order using the following strategies: (i)
submitting a market order at the beginning of the time period, (ii) submitting a market order at
the end of the time period, and (iii) submitting a limit order at the beginning of the time period
and a market order for unexecuted share at the end of the time period.
Handa and Schwartz [22] analyzes the profitability of the third strategy comparing to the first
one. The limit order strategy that they study is to submit a limit order placed l percent below
the current price, where l is set to 0.5, 1, 2 and 3. The limit order is followed until it executes or
until the last price in the trading window is reached. If the limit order does not execute during
the trading window, the stock is purchased at the opening price on the day following the trading
window. The experimentation results indicate that return of limit order conditional on execution
are positive, while return of limit order conditional on nonexecution are negative. They also find
that picking off risk is not a cost to limit order traders, but that nonexecution is. Thus, it is more
appropriate for liquidity trader to transact by the market order strategy, while traders who gain
relatively little by trading at current prices (and who are willing to risk not executing) may prefer
the limit order strategy.
Another study comparing the profitability of these three choices by Nevmyvaka, Kearns, Pa-
pandreou, and Sycara [37] suggests that the limit order strategy performs better than the market
order strategy. Although this may seem to contradict with [22], they study the limit strategy in a
finer detail. Specifically, they present a method to estimate return, risk, and risk-return profiles of
each strategy from historical data as well as a method to derive optimal pricing frontiers based on
the tradeoff between risk and return. Their quantitative method allows traders to optimally price
their limit orders to minimize trading costs and control corresponding risks. The importance of a
number of microstructure variables (e.g. order size, time window and liquidity) is also highlighted.
Static strategies for informed traders

Unlike liquidity traders, informed traders do not have a responsibility to fill the trade when
the deadline is approached. Thus the decision these traders faced is simply whether to trade
aggressively by submitting a market order or to trade passively by placing a limit order. This
static decision problem is usually formalized as an optimization problem that considers the tradeoff
between the payoff associated with limit orders and the risk of non execution. On one hand,
traders would prefer to place their orders very far from the best bid/ask price because this will
increase their payoff. On the other hand, the larger the distance from the best price the larger the
chance that the order will not be executed. Thus, in this setting, traders have to find the right
tradeoff between these two opposite choices in order to maximize the expected profit obtained
from the trade. This section briefly review static order submission strategies for informed traders
previously proposed in the literature.
Parlour [39] presents a model of the evolution of the limit order book. The optimal choice be-
tween submitting a limit order and a market order is characterized as a single-period optimization
model. The central intuition of her research is that each trader knows that his order will affect
the order submission strategies of other traders who follow; thus, he take this effects into account,
which in equilibrium, generate systematic patterns in prices and order placement strategies even
without asymmetric information. Her study also suggests that both side of the order book are
important in determining an agent’s order choice.
Foucault [16] describes a game theoretic model of price formation and order submission decision
in a dynamic limit order market where traders arrive sequentially and choose to submit either a
market order or a limit order with one-period life. His result indicates that (i) the proportion of
limit orders in the order flow is positively related to asset volatility, (ii) the ratio of filled limit
orders to total number of limit orders is negatively related to asset volatility, (iii) the proportion
of limit orders is positively related to the average size of the spread, (iv) the increase in trading
cost at the end of the trading day is negatively related to the level of competition between limit
order traders and (v) the size of the sum of trading costs for buy and sell orders is maximum
when the ratio of buy to sell orders, is equal to one.
Hollifield, Miller and Sandas [27] present empirical restrictions of a model of optimal order
submission in limit order market. A trader’s optimal order submission depends on the trader’s
valuation of the asset and the trade-offs between order prices, execution probability, and picking
off risks. The optimal order submission strategy is a monotone function of a trader’s valuation,
characterized in term of threshold valuations. The threshold valuations are functions of the order
prices and the trader’s subjective beliefs about the execution probabilities and picking off risks.
Foucault, Kadan and Kandel [17] proposed a dynamic model of a limit order market populated
by strategic liquidity traders of varying impatience who aim to optimize the tradeoff between the
cost of delayed execution and the cost of immediacy (the spread). The optimal order submission
strategy of each trader is modeled as a single period optimization problem. Under several sim-
plifying assumptions, they derive the equilibrium order placement strategies. They find that the
proportion of patient traders in the population and the order arrival rate are the key determi-
nants of the limit order book dynamics. Traders submit aggressive limit orders, which improve
current best quote by large amounts, when the order arrival rate is low or when the proportion of
patient traders is larger. As a result, markets with a high proportion of patient traders or a small
order arrival rate are more resilient. Also, a reduction in the tick size reduces market resiliency,
and, in some case, increases the average spread. Their analysis also yields several testable pre-
dictions: (i) a positive relationship between inter-trader durations and market resiliency, (ii) a
negative relationship between the order arrival rate and market resiliency, (iii) a joint decline of
limit order aggressiveness and market resiliency at the end of the trading session and (iv) limit
order traders submit more (less) aggressive orders when the spread is large if patient (impatient)
traders dominate the trading population.
Lillo [31] considers the problem of the optimal limit order price for a financial asset in the
framework of utility maximization. The analytical solution of the problem gives insight on the
origin of the recently empirically observed power law distribution of limit order prices. In the
framework of the model, the most likely proximate cause of this power law is a power law hetero-
geneity of traders’ investment time horizons.
3.1.2 Dynamic order submission strategies

Unlike static order submission strategies, dynamic order submission strategies allow traders to
monitor the changing market conditions and make changes to their order any time before the order
expires or is executed. Empirically, traders change their order submission as market conditions
change. They continuously monitor the market and make appropriate changes to their orders
whenever necessary. For example, to reduce the execution risk, they may convert their limit order
to market order when the demand for immediacy increases. They may also reprice or cancel
their limit orders when the underlying value of the asset changes to manage the adverse selection
cost. Hence, it is more appropriate to model this decision with dynamic strategies than with
static strategies. This section presents the existing dynamic strategies previously proposed in the
literature.
Cohen, Maier, Schwartz and Whitcomb [11] consider an order submission strategy as a dy-
namic optimization problem. Traders in their model may seek to trade via limit order, trade with
certainty via a market order, or not to trade at all. Their result demonstrates that transaction
costs cause bid-ask spread to be an equilibrium property of financial markets since, with trans-
action costs, the execution probability of a limit order does go to unity as the order is placed
infinitesimally close to the opposite market quote; thus, with certainty of execution at the op-
posite market quote, a ”gravitational pull” that keeps the opposite quotes from being placed
infinitesimally close to each other is generated. They also define an equilibrium market spread
and illustrate that it is negatively related to the order arrival rate.
Harris [24] derives optimal dynamic order submission strategies for trading problems faced by
three stylized traders: an uninformed liquidity trader, an informed trader and a value-motivated
trader. Separate solutions are obtained for quote- and order-driven markets. Their results suggest
that traders are most aggressive when volatility is high and when their information advantages,
if any, are large and decay quickly. Traders are patient when their deadlines are not pressing
and when bid/ask spread are wide. The numerical results suggest that most traders should place
limit orders close to the market when they trade. Although it may sometimes be optimal for
risk neutral traders to place orders far from the market (when deadlines are distant or when
private information will not be revealed soon), the expected additional benefits from this strategy
are very small. If monitoring of open orders is expensive or if the trader is risk averse, distant
order placement strategies will not be optimal. The only exception to this rule is for traders who
believe that prices are mean-reverting. They may place limit orders far from the market to benefit
if prices move far from fundamental values.
Nevmyvaka, Feng and Kearns [36] present the first large-scale empirical application of re-
inforcement learning to the problem of trade execution. In their problem, the goal is to sell
(respectively, buy) V shares of a given stock within a fixed period of time in a manner that
maximizes the revenue received (respectively, minimizes the capital spent). Their results indi-
cate that introducing market variables into the model can greatly improve the execution result
and reinforcement learning can indeed result in significant improvement over simpler forms of a
single-period optimization model.
Wang and Zhang [45] present a dynamic focus strategies that incorporate a series of market
orders of different volume into the limit order strategy and dynamically adjusts their volume
by monitoring state variable such as inventory and order book imbalance in real-time. The
sigmoid function is suggested as the quantitative model to represent the relationship between the
state variables and the volume to be adjusted. The empirical results indicate that the dynamic
focus strategies can outperform the limit order strategy, which does not adopt dynamic volume
adjustment.
Slive [43] derives the optimal dynamic order submission strategies of a trader in a limit order
market who has the ability to actively monitor his order and use cancellations and order changes
to mitigate the adverse selection and execution risks inherent in limit orders. His results suggest
that the ability to implement a dynamic strategy has a large impact on the payoffs to submit
limit orders and on limit order submission strategy of a trader. After calibrating the parameters
to a stock on the Vancouver Stock Exchange, profits from limit order submission are 48% higher
when implementing a dynamic strategy compared to a one-shot strategy. Cancellations and order
changes are used to avoid adverse selection by moving orders when the underlying value changes.
Order changes are used to mitigate execution risk by converting to a market order when the
probability of execution declines.
Although recent empirical studies [7, 19, 41, 44, 6, 33, 20, 18, 10, 34] indicate that trader’s
decision of when and which order type to submit is significantly influenced by the state of the
order book (e.g. the queue volume, the market depth, and the inside spread) as well as its dynamic
(i.e. recent changes to the order book), little attention has been paid to develop a dynamic order
submission strategy that utilizes this information to optimize trade execution. Notable exceptions
are Nevmyvaka et al. [36] and Wang and Zhang [45] who propose quantitative methods that allow
traders to optimally price their limit orders with the aim to minimize trading costs based on the
state of the order book. While their results indicate that incorporating market conditions into the
decision can greatly improve the execution result, their works can only be applied to solve trading
problem of liquidity traders. Thus, all of these suggest us to develop a new order submission
model that incorporate this information and can be utilized to solve all three trading problems
as in Harris [24].
3.1.3 Framework for order submission strategy

To establish the link between model of limit-order execution and order submission strategy, this
section presents a framework to optimize order submission strategies based on the tradeoff consid-
ered by theoretical order submission model. A single-period model that can be utilized to derive
static order submission strategy is firstly presented. Then, a multi-period model for deriving
dynamic strategy is discussed.
Single-period Model
In single-period setting, the order submission decision is viewed as a one-shot game where traders
can make their decision only once. If he decides to submit a limit order, no additional change
can be made to his order and it will stay in the order book until it is executed or the end of
the trading period. Assume that a trader wants to transect q shares of a particular financial
instrument within a specific trading horizon T . At the time of decision t, the investor is faced
with three possible choices:
1. Do nothing.
2. Submit a market order to immediately transact q shares at the current market price pM
t .
3. Submit a limit order to transact q shares at a specific limit price pL

t .
To model these choices, the trader needs to specify the objective of the trading by defining two
payoff functions: a function fe (p, q) that defines the payoff he will get when he transact q shares
at a price p, and a function fnt (q) that defines the cost he needs to pay if he is not able to trade
q shares of that instrument. By specifying the form of these two functions, all three problems
mentioned in the beginning of this section can be formalized in the same framework. The liquidity
traders who has a responsibility to fill the trade before the deadline can set fnt (q) = −∞ so that
the strategy should always fill the trade when the deadline is reached. Informed traders may set
fe (p, q) to be the difference between the execution price and their private value of the asset. For
valued-motivated traders, these two functions will be time dependent.
If the trader chooses to do nothing, he will pay a cost of not trading which is equal to fnt (q).
If the trader chooses to submit a market order, his order will be immediately executed and he will
receive a payoff of fe (pMt , q). If the trader chooses to submit a limit order, one of three events can
occur: the limit order may be fully executed, partially executed, or not executed at all. When
the order is not fully executed, he will have a choice either to submit a market order to transect
the unexecuted shares or to do nothing depended on his trading objective. If the limit order is
executed for q e shares, the payoff the trader get will be:
fl (pL e L e M e e
t , q, q ) = fe (pt , q ) + max{fe (pT , q − q ), fnt (q − q )} (3.1)
This payoff is a random variable since its value depends on the number of executed share q e and
the future market price pMT , whose values are not known beforehand, and this expected payoff
can be calculated by taking expectation over q e and pM
t as in the following equation:
Eqe ,pM
t
[fl (pL e L e
t , q, q )] = Eq e [fe (pt , q )] + max{Eq e ,pM
t
[fe (pM e e
T , q − q )], Eq e [fnt (q − q )]} (3.2)
If the payoff function fe (p, q) and fnt (q) are linear in q, which is usually the case, the expected
payoff the trader gets from submitting a limit order will be:
Eqe ,pM
t
[fl (pL e L e M e e
t , q, q )] = fe (pt , Eq e [q ]) + max{EpM [fe (pT , q − Eq e [q ]]), fnt (q − Eq e [q ])} (3.3)
T
To simplify this computation, previous works usually assume that when a limit order is executed,
it is satisfied fully at the stated price (except for [27]). Given a vector of variables describing
market conditions Xt , the expected payoff in this case is reduced to:
UT,Xt (pL L e L L L L
t ) = Eq e [fl (pt , q, q )] = P (pt , q, T, Xt )fe (pt , q) + (1 − P (pt , q, T, Xt ))fne (pt , q) (3.4)
where P (pLt , q, T, Xt ) is the execution probability that a limit order to transact q shares at price
L
pt will be fully executed before the end of the trading horizon T under the market condition Xt ,
and fne (pL
t , q) = max{EpM [fe (pMT , q)], fnt (q)}.
T
To determine the optimal order choice, the trader will select the choice that maximizes their
expected payoff. Although there are three possible choices (i.e. do nothing, submit a market order,
and submit a limit order), the expected payoff of all these choices can be represented by using the
same expected payoff equation UT,Xt (pL L
t ) with different value of the limit price pt . In the case of
buying, the do nothing choice can be represented by very low limit price so that the probability
of execution is zero. Accordingly, the market order choice can be represented by setting limit
price to be higher than current market price pM t so that the probability of execution is equal to
one. Hence, the optimal choice for the trader is the value of pL L
t that maximizes UT,Xt (pt ) , i.e.,
pbL
t ≡ arg maxpL t
[UT,Xt (pL L
t )]. In order to explicitly derive the functional form of UT,Xt (pt ) we need
to find the expression for P (pL t , q, T, Xt ) which will be the main subject of the next section.
Multi-period Model
In multi-period setting, the trading horizon T is further divided into a smaller period indexed by
t ∈ {0, ..., T }. At any specific time t, the investor observes the current state of the market Xt ,
and he then chooses an action θt ∈ Θ(Xt ) which can be either resubmitting an order at price pL t
or canceling the previously submitted order. The action space of the investor can be described as
Θ(Xt ) = {pL L
t } ∪ {C}, where C denoted cancellation. If θt 6= pt−1 , the trader will amend his order
price and his order goes to the back of the time priority queue at the new price. If the trader set
his new price such that the price is better than the opposite side best price, he has converted his
order to a market order that will transact immediately.
To determine the optimal order submission strategy, the trader chooses his action at each time
to maximize his expected payoff over the trading horizon. This problem can be formulated as
a stochastic dynamic optimization problem with a finite horizon and a finite action space. The
formal description of the valuation function consists of two parts.
ut (Xt , qt ) = max {Et,qte [fe (θt , qte ) + ut+1 (Xt+1 , qt − qte )]} (3.5)
θt ∈Θ(Xt )
subject to the boundary condition uT (XT , qT ) = max{fe (pM T , qT ), fnt (qT )} depending on the
trading problem the trader wants to solve. Like in the single-period model, most of the previous
works usually simplify this calculation by assuming that when a limit order is executed, it is
satisfied fully at the stated price. In this case, the valuation function is reduced to:
ut (Xt , qt ) = max {P (θt , q, Xt )fe (θt , q) + (1 − P (θt , q, Xt ))Et,qte [ut+1 (Xt+1 , q)]} (3.6)
θt ∈Θ(Xt )
where P (θt , q, Xt ) is the one-period execution probability of a limit order to transect q shares at
price θt .
3.2 Limit-order execution models

Models of limit-order execution that can be used to predict the probability of execution, a prob-
ability that a given limit order will be executed in a specified period of time, is one of the most
important components to determine an appropriate order submission strategy for a trader in an
order-driven market since the expected payoff the trader may get from submitting a limit order is
largely depended on such probability. Although several methods have been proposed to model this
probability, we believe that they have several limitations that prevent their use in real situations.
This section presents a recent review on the methods for modeling this probability. The limitation
of each method is also highlighted in order to guide the direction for further developments.
Generally the life of every limit order can end up in three different outcomes: fully executed,
partially executed or unexecuted. For a fully executed order, one can defined time-to-fill as an
elapsed time between its placement and its complete execution. Since orders are usually not fully
executed by one transaction, the time from order placement to the first transaction this order
participates in can also be defined as time-to-first-fill. Theoretically, a limit order will be executed
only when enough market orders arrive during the remainder of the trading horizon to execute
all preceding orders in the book; thus, the probability of execution must depends on both the
state of the book when the trader submits his order and the future market order flow of other
traders which depends on current market conditions. Hence a good limit-order execution module
should incorporate this information into consideration. To model the probability of execution,
previous works either directly attempt to model the probability distribution of those three different
outcomes [38] or attempt to model the probability distribution of execution time (i.e time-to-fill
and time-to-first-fill) and then utilize it to derive the execution probability [32, 31, 14]. The
relations between the probability of each outcomes and the execution time distribution are:
P r(F ullyExecuted|T, O, X) = P r(T T F ≤ T |O, X) (3.7)
P r(P artiallyExecuted|T, O, X) = P r(T T F F ≤ T |O, X) − P r(T T F ≤ T |O, X) (3.8)
P r(U nExecuted|T, O, X) = P r(T T F F > T |O, X) = 1 − P r(T T F F ≤ T |O, X) (3.9)

where T is the trading period, X is a vector of explanatory variables that captures market condi-
tions and the state of the order book, and O is a vector of variables describing information about
the limit order (e.g. the number of preceding orders in the book, the limit-order price, the order
size, and side indicator).
The rest of this section is organized as followed. Previous works that model the probability of
execution directly are discussed in section 3.2.1. Section 3.2.2 reviews previous works that model
the execution time and utilize it to calculate the execution probability.
3.2.1 Execution probability models

This section describes methods that model the execution probability directly. These methods can
be classified into two main categories, which are theoretical models and empirical models.
Theoretical models
Since the execution probability depends on future traders’ order submission, an order submission
model that describes traders’ behavior can be utilized to determine the execution probability.
Given the model of the market together with the distribution of traders and their valuation, the
execution probability in an equilibrium1 can be derived (See [39, 16, 17] for examples). Specifically,
assuming that all traders in the market are rational and use the same optimal order submission
strategy, the execution probability of the limit order can be estimated by calculating the proba-
bility that other traders will submit an order to trigger our limit order.
For example, Foucault [16] studies a market for a single risky asset whose trading day is
divided into discrete time intervals denoted t = 1, 2, ..., T , where T is a random stopping time,
and, at each t, the probability that trading will terminate is (1−ρ). When the trading terminates,
the payoff of the asset, whose value is constant and equal to v, will be realized. At each time
t, a trader who is characterized by the reservation price, Rt = v + yt , arrives. Yt can take two
value yh = +L or yl = −L with probability k and (1 − k), respectively. Thus, in this market,
there are two types of traders: the yh type only place buy orders and the yl type who only place
sell order. Consider a trader of type yh who arrive at time t. Let B be the bid price this trader
choose if he posts a buy limit order. This order will be executed only if (i) the game does not
stop before the arrival of the next trader (with probability ρ), (ii) the next trader is type yl (with
probability (1 − k)), and (iii) the next trader submit a market order. The probability of the last
event is endogenous and depends on the bid price. In particular, if the bid price is too low, the
yl -type trader will be better off posting a sell limit order. However, if the bid price is greater than
the price that yl -type trader is indifferent between market order and a limit order, this buy limit
order will be executed with probability ρ(1 − k). Foucault illustrates that this threshold price is
1−ρ(1−k)
θh = v − L + 1−ρ 2 k(1−k) (2L).
Another example is an equilibrium model of Parlour [39]. In her model, there is an asset
that are traded on day 1 and pays off a certain amount V on day 2. On day 1, at each times
t = 1, 2, ..., T , a randomly drawn agent arrives at the market. Agents are characterized as potential
buyers or sellers with probability πb and πs respectively. A potential buyer has an endowment of
cash that can use to purchase one share. On the other hand, a potential seller holds one share
which can be sold for cash. Agent t’s preferences are given by a utility function U (C1 , C2 ; βt ) =
C1 + βt C2 , where C1 is agent’s consumption on day 1, C2 is agent’s consumption on day 2 and
βt is a trader’s personal trade-off between C1 and C2 . The parameter βt determines an agent’s
willingness to trade and is assumed to be randomly distributed over an interval (β, β) with some
continuous distribution F (.). Normally, a potential seller with a low value of βt will be eager to
sell, while a potential buyer with a low value of βt will be disinclined to buy. All agents have
only one opportunity to submit orders, and, once they submit an order, the order cannot be
withdrawn. The market, in this setting, is characterized by the designated bid and ask price B, A
1
In an equilibrium, optimal order submission strategies are determined based on the execution probability which
is computed by assuming that all traders follow the same strategy
and a limit order book bt . The limit order book is described by the number of shares on the
bid and ask sides, bB A
t and bt , immediately prior to the arrival of agent t. The optimal strategy
for each agent in this market can be determined by recursively working backward from time T .
Particularly, the agent at time T has two options whether to trade using limit order or to do
nothing. If the agent is a potential seller, he will compare the utility of doing nothing (βT V )
with the utility of selling at the bid (B). If βT V < B, then he will enter a market sell order.
Giving a particular distribution for βT , the probability that the agent T will enter a market sell
order can be computed. A similar computation can be utilized to compute the probability of a
market buy order at time T . For the agent arrive at time T − 1, if he is a buyer and bB T −1 = 0,
he can enter a buy limit order which will be executed if agent T enter a market sell order, the
probability of which we just computed. If bB T −1 ≥ 1, agent T − 1’s limit buy will not be first in
the execution queue, and, thus, cannot be executed in the one remaining period. Given agent
T − 1’s direction, the limit order book bT −1 , and the limit order execution probability, Parlour
Buy
illustrates that there are cutoffs β Buy
Limit
and β Limit such that if βT −1 < β Buy
Limit
, agent T − 1 will
Buy Buy
do nothing; if β Buy
Limit
< βT −1 < β Limit , he enters limit buy order; and if βT −1 > β Limit , he will
enter a market buy order. Given a distribution of βT −1 , the probability of these events can be
computed and utilized to define the execution probability for time T − 2 which defines agent T − 2
optimal strategies, and so on.
Although the results obtained from these analytical studies may not be appropriated for real
situations since they depend on the assumption about the market model which is usually a lot
simpler than the real market, these results provide us more understanding about the relation
between the execution probability and other related variables.
Empirical models
Apart from using analytical methods, we can also utilize historical data on trades and quotes to
estimate the execution probability. Given a specific limit of time, the execution probability can
be defined as a ratio of the number of limit orders that are executed within that limit to the total
number of orders submitted to the market. This definition has been utilized by several authors
including Omura et al. [38] and Hollifield et al. [27]. To estimate the execution probability, the
main task of this model is to determine whether the limit order is executed in the specified period
of time or not. If every action relating to each limit orders is time-stamped in our historical
data, this task will be very easy to achieve. However, in real situations, we can observe only
the change in quantities of limit orders in the limit order book and information about the trade
(i.e. execution price and its volume). Thus, some approximation methods should be employed to
estimate the time that the order is submitted to the market as well as the time that the order is
executed.
One example of such approximation is the work of Omura et al. [38] who analyze the execution
probability of limit orders on the Tokyo stock exchange. Their dataset contain information about
any changes in quantities of the limit order at the best bid and the best ask, and to an execution
price and its volume. They reconstruct the market order flow using the following rule. Suppose
that at time t an execution is recorded. Let Pt be the execution price at time t, Vt be the executed
amount in share, Askt− be the ask price, and Bidt− be the bid price just before the execution
occurs. If they observe P t = Askt− , then the execution is carried out by an incoming market buy
order of the size Vt . If Pt = Bidt− , then there is a market sell order of the size Vt . To reconstruct
limit order flow, they trace any changes that occurred in the limit order book. Suppose that no
execution occurs at time t. If at time t − 1 an execution occurs, then the change in the book from
t − 1 to t is solely caused by the execution at t. They will disregard this t record for the purpose of
constructing incoming limit order flow. If instead, there is no execution at time t − 1, the change
in the book must be caused by either a submission or a cancellation of limit orders. Let ALmtt
be a placed sell limit order at time t, AskVt and AskVt−1 be the amount of sell side of the book
at time t and t − 1, respectively. When the ask prices Askt and Askt−1 at the consecutive times
are the same, then the amount of orders changed is:
ALmtt = AskVt − AskVt−1 , if Askt = Askt−1

When an investor places a competitive limit sell order at a lower limit price than the current
best ask, the new depth AskVt is the amount of this submission.
ALmtt = AskVt , if Askt < Askt−1

For the bid side, the number of placed/canceled buy limit orders at time t is:

BidVt − BidVt−1 , if Bidt = Bidt−1 ,
BLmtt =
BidVt , if Bidt > Bidt−1
To determine whether the limit order is executed or not, they make an assumption that a
limit order is executed if there are more market order arriving than the amount of the depth the
limit order creates. Let ALmtt and BLmtt be the amounts of the limit orders submitted at time
t when the previous depth of the book are ABookt− and BBookt− . Then, the sell limit order
ALmtt is executed if:
T
X
ABookt− + ALmtt ≤ AM kts
s>t
where T indicates the trading period, and AM kts , t < s ≤ T , indicates the amount of the buy
market order with an execution price higher than or equal to the limit price Askt that arrives
after the submission of the sell limit order of the limit sell order ALmtt . Similarly, a buy limit
order BLmtt is executed if
T
X
BBookt− + BLmtt ≤ BM kts
s>t
where BM kts , t < s ≤ T , is the amount of the sell market order with an execution price lower
than or equal to the buy limit price of the limit order BLmtt .
To estimate the execution probability, they assume that a limit order remains on the book until
the closing of the day it is submitted. Thus, they ignored all cancellations, and this may cause
underestimate of the execution probability especially when the preceding limit orders, ABookt−
or BBookt− are cancelled. In such case, the limit order concerned may be actually executed, but
the method may fail to recognize it.
Although we can utilize this approach to estimate the probability of execution, the main
drawback of this approach is that it depends on the specific time period. If the trading period of
the trader changes, the execution probability must be recalculated.
3.2.2 Execution time models

Instead of directly modeling the probability of execution, we can also model the distribution of
execution time and utilize it to estimate the execution probability. The main advantage of this
approach, with respect to the former one, is that the trading time is the parameter of the model.
Thus, if traders’ trading horizon changes, they do not need to recalculated the model to obtain
the execution probability.
Related methods for modeling such distributions can be separated into two main categories
which are first-passage time models and empirical execution time models.
First-passage time models

The execution time of a limit order can be approximated by a first-passage time of the asset price
process. In this content, the first-passage time is the first time that the price of an asset reaches
or crosses the limit order price. Specifically, let the price of an asset at time t = 0 be S0 . The
first-passage time through a prescribed level S0 + ∆ for a fixed distance ∆ > 0 is defined as the
first time when S(t) ≥ S0 + ∆. Similarly, a first-passage time for a level S0 − ∆ can be defined
as the first time when S(t) ≤ S0 − ∆. Theoretically, the first-passage time is a lower bound of
the time-to-fill, and it will equal to the actual time-to-fill only when the buy (sell) limit order is
at the top of the queue or close enough to the top so that it is filled with the first incoming sell
(buy) order. The first time that the asset price falls below (rises above) the limit buy (sell) price
can also be thought of as an upper bound of the time-to-fill since the asset price can cross the
limit price only when all orders at the limit price are executed. Thus relationships among the
first-passage time, time-to-first-fill and time-to-fill of a limit sell order at S0 + ∆ are:
F P T (∆) ≤ T T F F (∆) ≤ T T F (∆) ≤ F P T (∆ + ) (3.10)
where is the tick size of the asset. By modeling the property of the first-passage time, one can
utilize it to estimate the property of time-to-first-fill and time-to-fill of an interested asset. For
example, one can use the first-passage time as an approximation of the time-to-fill and use it to
estimate the probability of execution using the following equation:
P r(F ullyExecuted|T, O, X) = P r(T T F ≤ T |O, X) ≈ P r(F P T ≤ T |O, X) (3.11)
However, the probability obtained from this estimation usually overestimates the actual execution
probability since the estimated first-passage time is typically lower than the actual time-to-fill2 .
The property of the first-passage time of a particular financial instrument can be modeled
both by theoretical and empirical approaches. On the theoretical side, the statistical property of
the first-passage time can be explicitly derived if a stochastic property of the asset price process
is given. For example, if the dynamic of the asset price S(t) is given by a Brownian motion with
diffusion rate σ, the probability distribution of the first-passage time will be [15]:

∆ ∆2
f (∆, t) = √ exp √ (3.12)
2πσ 2 t3 2σ 2 t
2
The reason why the estimated first-passage time is typically lower than the actual time-to-fill is that when the
asset price first reaches the limit price the order will be executed only when it is the first order in the queue. Thus,
the time-to-fill is usually longer than the first-passage time.
Using equation (3.11), the probability that the limit order is fully executed during a specific
trading period T can be approximated as (see [31] for example):
Z T
∆
P r(F ullyExecuted|T, ∆, σ) ≈ P r(F P T ≤ T |∆, σ) = f (∆, t)dt = erfc √ (3.13)
0 2σ 2 T
Although many stochastic processes (e.g. geometric Brownian motion and Markov processes)
can be applied in this context, the estimated result is largely depended on the asset price model
specification. If this specification is not appropriate, the estimation error can be incredibly large.
For example, if the asset price exhibits a short-term mean revision but a geometric Brownian
motion is utilized to model the execution time, the predicted execution time will largely underes-
timate the real execution time as reported in [32]. To amend the problem, one can use empirical
approaches that directly model the first-passage time using historical time series of transactions
data (see [5, 22] for example). The primary advantages of such approach to statistical models is
that if the stochastic process for the asset prices exhibits mean revision or more complex forms of
temporal dependence and heterogeneity, this will be automatically incorporated into the empirical
model. While empirical approach can solve model specification problem, the first-passage time
model still suffers from several other important limitations. The most obvious weakness is the
assumption that the order is executed when the limit price is first attained; hence, the model
can not be easily modified to handle the variation of limit order sizes as well as the distinction
between time-to-first-fill and time-to-fill. In addition, it cannot easily incorporate the effects of
explanatory variables such as market conditions and the state of the order book. Thus, although
the first-passage time model is a natural theoretical framework for modeling the order executions,
it leaves much to be desired from a practical point of view.
Empirical execution time models

To resolve the central weakness of the first-passage time models, it is more appropriate to construct
models of limit-order execution using the actual execution time, i.e., an elapsed time between the
order placement and its complete execution for time-to-fill, and the time from order placement
to the first transaction this order participate in for time-to-first-fill. To achieve this, we need
information about the time when an order is submitted and when it is executed. In particular,
all information about every action relating to the order during its lifetime must be time-stamped
and recorded to make it possible to calculate the execution time. Thus, more data is required to
utilize this approach than to utilize the first-passage time models that require only historical time
series of transactional data.
After obtaining the information about time-to-fill and time-to-first-fill of each executed order,
one may directly utilizes this information to model the execution time distribution (see [15] for
example). Unfortunately, discarding information about unexecuted orders from the model would
clearly bias the empirical distribution towards shorter execution times because unexecuted orders
are usually orders that have to wait for a considerable amount of time for their execution so
that they are usually cancelled before they get executed. Nevertheless, since these orders are
not executed, it is not possible to directly calculate the execution time distribution for these
unexecuted orders. To solve this problem Lo et al. [32] utilize survival analysis, a form of
conditional logistic regression analysis that allows censored observations3 , to model the execution
3
In this content, censored observations are unexecuted orders that expire or are canceled before they are executed.
time distribution. The advantage of such approach is that information from unexecuted orders can
be easily and correctly accommodated. The idea behind this is that although we can not calculate
the exact execution time of unexecuted orders, we know that if these orders were executed their
execution time should be at least as long as their lifetime. In addition, survival analysis also
enables us to estimate the execution time distribution as a function of dependent variables such
as information about the order (e.g. limit price and order size), state of the order book and
market conditions. This property is very important since recent empirical research suggests that
the execution probability is largely depended on these variables [38], and, without the ability to
incorporate these variables into the model, the result may not be accurate.
Although empirical execution time models based on survival analysis seem to be a good can-
didate to model the execution probability since it can solve all the mentioned problems, they still
have some limitations concerning its use in developing an order submission strategy. The most
important limitation is the inability to estimate the expectation over the filled quantity mentioned
in equation 3.2 and 3.5. Although they can be used to estimate the expectation of the simplified
models mentioned in equation 3.4 and 3.6, these simplified models are based on the assumption
that, when a limit order is executed, it is satisfied fully at the stated price, which usually does
not hold especially for a large limit order.
3.3 Summary
This section presents an overview of order submission strategies together with it relation to
models of limit-order execution. Although recent empirical studies indicate that a trader’s order
submission strategy is largely influenced by the state of the order book and current market
conditions, little attention have be paid to develop a theoretical model to optimize such strategy.
Most of the theoretical models consider this problem as a trade-off between the free-trading
option and the expected profit, which is largely depended on the execution price and the execution
probability. Thus, one of the most important factors to make such decision is a model of execution
probability. Consequently, a natural choice to develop an order submission strategy that utilizes
this information is to incorporate it into the model of execution probability. However, all of the
previous methods to model such probability still have limitations and need further development.
Specifically, an ideal limit-order execution model should be able to incorporate the information
about market conditions and the state of the order book as well as to estimate the expected profit
of limit order trading without the assumption that when limit order is executed it is satisfied fully
at the stated price.
Chapter 4
Research Proposal
4.1 Hypothesis
Traditional order submission models usually do not use information about market conditions
(i.e. the state of the order book and its dynamic) to make trading decision. However, recent
empirical investigations suggest that traders’ order submission decision is largely depended on
this information and incorporating it into the decision model can greatly improve the execution
result. One way to achieve this is to develop a model of limit-order execution that utilize this
information as a determinant to determine the execution probability of limit orders and utilize
the resulted execution probability to derive the optimal order submission strategy.
4.2 Problem statement

The objective of this research is to develop a computational model of limit-order executions in an
order driven market that utilize information about market conditions to predict the probability
that a giving limit order will be executed in a specified period of time as well as investigate the
optimal way to utilize the developed model to make order placement and trading decision in
algorithmic trading systems. Thus, this research has two main challenging tasks:
1. Develop a model of limit-order execution that utilizes information about market conditions
to estimate the execution probability of limit orders. To achieve this, several limitations of
previous models will be examined and improved in the following directions:
• The developed model will incorporate the explanatory variables (i.e. market conditions
and the state of the order book) to estimate the execution probability.
• The developed model will consider all orders in the order book rather than consider
only newly submitted orders as in previous models so that the developed model can
be utilized to analyze the dynamic of the execution probability with the aim to gain
more insight on the determinants of the execution probability and how this probability
changes over time.
• The developed model will be able to handle the variation of order size as well as to
estimate the expected fill quantity of a limit order.
31
CHAPTER 4. RESEARCH PROPOSAL 32
2. Develop an order submission model that utilize the execution probability estimated from the
developed limit-order execution model to optimize trade execution. Although recent em-
pirical investigations suggest that traders’ order submission is largely depended on market
conditions and incorporating this information to make order submission decision can greatly
improve the execution result, little attention has been paid to develop an order submission
strategy that utilizes this information to optimize trade execution. By utilizing the ex-
ecution probability from the developed limit-order execution model that utilizes market
conditions to estimate the execution probability, the developed order submission model will
accordingly utilize market conditions to make order submission decision, and, thus, an or-
der submission strategy produced by the developed model is expected to be better than the
strategy produced by traditional models that do not utilize this information.
4.3 Expected contributions

Upon successfully finishing this research, we expect to have introduced a new model of limit-order
execution that models all orders in the order book based on the information about the order book
and its dynamic as well as a new order submission model that can be utilize to make order
submission and trading decision in algorithmic trading systems. Our expected contributions are
as follows:
1. A literature review of models of limit-order execution in an order driven market.
2. A new probability model of limit-order execution that models all orders in the order book.
3. Analysis of determinants and dynamic of the execution probability.
4. A new order submission model that utilize the developed order execution model to estimate
the execution probability
4.4 Scope of the research

This research develops the limit-order execution model and the order submission strategy only
for pure limit order book markets.
4.5 Validation of contributions

The contribution of this research will be validated through a running of different experiments using
both simulated data generated from artificial market models and real historical data collected from
Multi Commodity Exchange of India (MCX). The result from each experiment will be recorded
and, then, analyzed against those produced by traditional models. The prediction accuracy of
limit-order execution model will be judged using graphical method (e.g. Q-Q plot) and goodness
of fit. The effectiveness of the developed order submission strategy will be measured in term of
the profit gain from using the developed strategies.
Chapter 5
Research Plan
The research activities that need to be carried out to achieve the contributions of this research
can be categorized into five main tasks, which are:
• Task 1: Implement tools to collect real-time data for experiments and analysis,
• Task 2: Implement simulation models of a pure limit order book to generate data for
experiments and analysis,
• Task 3: Develop a virtual financial market environment which provides a testbed for subse-
quence experiments and analysis,
• Task 4: Develop new computational models of limit-order execution that incorporates vari-
ous explanatory variables and utilizes all orders in the order book to estimate the execution
probability,
• Task 5: Develop a new order submission strategy that can be utilized to make order sub-
mission decision in an algorithmic trading system.
The detailed information of each task will be summarized in the subsequence sections starting
from section 5.1 to section 5.5. To conclude the chapter, the timetable of this research will be
discussed in section 5.6.
5.1 Tools for real-time data collection

The main objective of this task is to develop a set of tools for collecting real-time market data from
several trading venues in order to utilize these data to analyze the correctness and effectiveness
of the developed limit-order execution model and order submission strategy. The trading venues
that we are interested in are Multi Commodity Exchange of India (MCX)1 , NYSE Arca (formerly
1
MCX is an independent commodity exchange based in India. It offers futures trading in Agricultural
Commodities, Bullion, metals, pluses, oils, energy, plantations, spices and other soft commodities. See
http://www.mcxindia.com/ for more information.
33
CHAPTER 5. RESEARCH PLAN 34
ArcaEX)2 . The reason why we interest in these trading venues is that they are pure electronic limit-
order book markets and we have an access to their real-time order book information. The real-time
information of MCX market can be collected from Reuters data feed that Thomson Reuters spon-
sors it to UCL free of charge. The real-time information of NYSE Arca market is obtained from
Arca Web Book service (accessible at http://www.archipelago.com/marketdata/book info.asp).
Since real-time information comes from two different sources, two different systems have to be
implemented. The system for collecting information from MCX market was implemented using
Reuters System Foundation API (SFC) Java Edition3 , while the system for NYSE Arca market
is a web robot that is scheduled to retrieve a snapshot of the order book from Arca Web Book
service every a specific period of time. Note that the developments of these two systems are
already finished and they are currently running to collect real-time information every single day.
5.2 Simulation models of pure limit order book markets

In order to further analyze the developed limit-order executions model and order submission
strategy in a control environment, a simulation model of a pure limit order book market that
imitates the dynamic process of real financial market is required. To achieve this, we plan to
implement two limit-order market models which are Preis et al. [40] and Mike and Farmer [35].
The reason why we choose to utilize the former model is that it is one of the simplest models
which is suitable for primarily analysis. On the other hand, the Mike-Farmer model is a very
powerful and realistic behavioral model that can successfully reproduce the whole distribution of
returns together with several other important stylized facts. Thus, it is very appropriate to utilize
the Mike-Farmer model for a thorough analysis before we experiment the developed model with
the data collected from real markets.
5.3 Platform for algorithmic trading system development

To analyze the performance of the proposed order submission strategy, it is necessary to have a
platform for developing, and experimenting with, an algorithmic trading system that utilize the
proposed strategy to make order submission decision. Therefore, the main objective of this task
is to develop a virtual financial exchange that imitates the behavior of limit order markets as well
as a programming library to develop an automated trading system to trade in such exchange.
The developed platform (i.e. the virtual exchange and the programming library) will be utilized
as a testbed for subsequence experiments and analysis.
The virtual financial exchange developed in this research will merge limit order data from two
sources: actively connected trading client, and limit orders from real financial markets collected
from the tools developed in section 5.1. Thus, in this environment, the limit orders submitted by
trading client are match not only with each other but also with limit orders from real financial
markets. The major advantage of incorporating real market limit order books in the simulation
2
NYSE Arca is a fully electronic stock exchange on which both stocks and options are traded. As of March
2007, NYSE Arca is the second largest Electronic Communication Network in terms of shares traders. Approx-
imately one out of every six shares traded on the American financial markets is traded on the system. See
http://www.archipelago.com/issuers/listing.aspx for more information.
3
More information about the SFC API can be obtained from Reuters’s customer zone website at
http://customers.reuters.com/developer/Kits/SFC/Java/SFC Java ProductOverview.aspx
is that it obviates the need for a so-called fill model to predict from price information alone
when limit orders would be executed [29]. Specifically, if only price information is available, a
simulation model must make a decision whether a limit order is executed or not when the asset
price crosses the limit price. A typical fill model might probabilistically execute the limit order
based on historical data and the volume of the order. In contrast, in our simulation, such models
are not required since a limit order will be filled only when there is a matched with the opposing
order just as in the real exchanges.
Once the virtual financial exchange is running, any number of automated trading clients can
connect to it and trade according to their programmed strategy. The communication between
the exchange and their clients will be implemented using the Financial Information eXchange
(FIX) protocol4 . To facilitate trading client development, a framework for developing a trading
client, that abstract the detail about the FIX protocol from trading clients by providing pro-
gramming functions for basic order management (e.g. submit, amend and cancel) and commands
for retrieving current status of the market (e.g. current order book and recent trades), will be
implemented.
5.4 Computational model of limit-order execution

As discussed in section 4.2, one of the main objectives of this research is to develop new limit-
order execution models that improve the limitations of previous models by extending them in
three main directions which are: (i) incorporating explanatory variables to estimate the execution
probability, (ii) utilizing all orders in the order book to analyze the dynamic of the execution
probability and (iii) handling the variation of order size to estimate the expected fill quantity.
This section briefly describes the techniques and ideas that we are going to utilize in order to
achieve these objectives.
To achieve the first objection, we plan to utilize the state of the art non-parametric modeling
techniques (e.g. Bayesian neural network and relevance vector machine) to model the distribution
of execution probability. The explanatory variables we plan to include in the model are bid-ask
spread, volume in the book, volatility, time of day, day of weeks, new schedule, trading history
and some of their derived value.
The second direction might be fulfilled by developing a technique to track the execution
probability of all orders in the order book and utilize this information to study the dynamic of such
probability. One way to do this is to create a conditional probability model that estimate current
execution probability given the information about past execution probabilities. Specifically, if
the execution probability at time t is represented by et , the conditional probability distribution
that we try to model are P r(et |et−1 , ..., et−n ) where n is the number historical time period we are
interested in.
Finally, to fulfill the last objective, we plan to investigate the relation between the number
of filled quantity and the execution probability so that we can use this information to derive the
expected fill quantity from the developed limit-order execution model.
4
The FIX protocol is a messaging standard developed specifically for the real-time electronic exchange of se-
curities transactions. FIX is a public-domain specification owned and maintained by FIX Protocol, Ltd. More
information is available at http://www.fixprotocol.org/.
5.5 Order submission strategy

The main objective of this task is to develop a new dynamic order submission strategy that has
the following properties: (i) it should be general enough to solve all order submission decision in
algorithmic trading system, (ii) it should incorporate market conditions into consideration. This
section briefly describes the techniques and ideas that we are going to utilize in order to achieve
these objectives.
To achieve the first objective, the developed model should be able to solve the three trading
problems mentioned in section 3.1. Thus, we plan to develop the model by using the order
submission strategies of Harris [24] as a baseline and extend it to create a more efficient model.
The second objective will be fulfilled by utilizing the execution probability from the developed
limit-order execution. Since the developed order execution model utilizes market conditions to
estimate the execution probability, the developed order submission model will accordingly utilize
market conditions to make order submission decision, and, thus, an order submission strategy pro-
duced by the developed model is expected to be better than the strategy produced by traditional
models that do not utilize this information.
5.6 Timetable
The timetable of this research is illustrated in the following figure.
Figure 5.1: Timetable of this research

Chapter 6
Work to Date
This section briefly describes all the works that I have done during the first year of my study.
During the first six months, I spend most of the time reviewing research articles in the emerging
field of Computational Finance. The result I get during this period is a review paper of this area.
After finishing the review, I found myself interest in the area of algorithmic trading which leads
me to further my research in this particular area. I also have an opportunity to design a virtual
trading platform and supervised a group of MSc student to develop it. The experiences I gain
from this opportunity help me understand more about the investment process as well as how to
apply computational methods to solve its problem. For the works that related to my research,
I developed a program to collect real time order book information from Reuters data feed (see
section 5.1) as well as developed a program to generate the empirical distribution of execution
probability from trade information.
The rest of this section is organized as follow: information about the virtual trading platform
will be described in section 6.1. Section 6.2 presents the method for generating the empirical
distribution of execution probability from trade information.
6.1 Banking science virtual trading platform

The Banking Science virtual trading platform is a platform that enables study and development
of computational techniques for trading and investments in financial markets. The platform forms
a tool to teach students about financial investment process and a platform to experiment with
new quantitative trading methods.
As illustrated in Figure 6.1, the platform comprises four main components: Data Presentation
and Analysis Control, Market Simulator, Virtual Hedge Fund, and Data Acquisition Control.
Users interact with the system though Data Presentation and Analysis Control which provides a
user interface to control the simulation process as well as to monitor and analyze the performance
of predefined investment strategies (each strategy will be represented by different virtual hedge
funds) that they are interested in. Market Simulator imitates the function of financial market,
broker and data provider by providing functions for other components to make buy/sell orders
as well as obtain financial data to make trading decision. Virtual Hedge Fund makes invest-
ment decision based on financial data received from Market Simulator. Data Acquisition Control
downloads financial data from Reuter Data Feed and stores it in the database.
37
CHAPTER 6. WORK TO DATE 38
Figure 6.1: Overview of Banking Science Virtual Trading Platform
I supervised nine MSc students to develop this platform, each of them responsible for each
component of the system. The number of students focused in each component is summarized in
Table 6.1.
6.2 Empirical distribution of execution probability

Most of the previous works focused on modeling the probability that a newly submitted limit
order will be executed in a specified period of time. To model this probability, the information
about order (i.e. the time when the order is submitted and executed) is required to compute the
life time of the order. The resulted models can then be used to infer information about the time
Component # of students
Market simulator 1
Virtual hedge fund 1
Trading strategy 1 4
Trading strategy 2 1
Execution strategy 2
Table 6.1: Number of students in each component

that a newly submitted limit order will be executed; however, these models have no information
about how these probabilities are changing over time since they model only the newly submitted
order. This limitation suggests us to construct an execution probability model of all orders in the
order book. When time goes by, a position of the order in the order book will be changed, and
the execution probability of the order should be changed accordingly. Surprisingly, it seems that
only trade data is enough to model this kind of probability.
Specifically, we can use trade data to estimate the following conditional probability, essentially
the CDF of the execution time Tk of a limit order k:
P r(Tk ≤ t|Xk , Ok )
where Xk is a vector of explanatory variables that captures market conditions and other condi-
tioning information, and Ok is a vector of variables describing information about the limit order
(i.e. location in the order book, limit-order price, size, and side indicator).
Unlike previous methods that model the probability of newly submitted order, we try to
model the probability of every order in the order book. Thus, we need some way to specify a limit
order that we would like to investigate. One way to do this is to use the location in order book
measured by the amount of the order preceding it. Consequently, an order can be represented
by a quadruple Ok = (Lk , Pk , Qk , Sk ) where Lk , Pk , Qk , Sk are location of the order, limit-order
price, size (in shares) and side indication (buy or sell), respectively.
As a starting example, assume that we want to estimate the probability that a limit order
Ok will be executed (time-to-first-fill) during the next t minute. In this case, the order can be
represented by a triple Ok = (Lk , Pk , Sk ) since quantity have no effect on time-to-first-fill. The
probability P r(Tk ≤ t|Ok ) can be estimated directly by counting the event that an order having
this specification will be executed during the next t minute. Using historical trade data, giving
a particular time, we can perform ”what-if” simulation to determine whether a specified order
will be executed during the next t minute or not. If we perform this simulation throughout the
available time period, the probability P r(T k ≤ |Ok) can be estimated by the ratio between the
number of time the order is executed and the number of time that we perform the simulation.
The outline of this process is illustrated in figure 6.2. The examples of empirical distribution of
execution probability generated from such approach is illustrated in 6.3.
Execution Probability(Ok ,t,historial data)
N, EN ← 0
for each timestamp ts in historical data
get all trades during ts and ts + t from historical data
perform simulation to determine whether there are enough trade to fill Ok
if Ok can be filled: EN ← EN + 1
N ←N +1
return EN/N
Figure 6.2: Outline of the method for generating an empirical distribution of execution probability.
Figure 6.3: Example of empirical distribution of execution probability generated from trade in-
formation.
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Order Submission Strategy

and Computational Models of Limit-Order Execution

October 23, 2008

1.1 Motivations from the literature and industry

1.2 Objectives of this research

1.3 Outline of this report

2.1 Market architecture

2.1.1 Limit order markets

Dealers in hybrid markets

2.2 The limit order book

2.3 Algorithmic trading

2.4 Trade execution strategies

2.4.1 Choice of trading venue

2.4.2 Choice of trade schedule

2.4.3 Choice of order type

3.1 Order submission strategies

3.1.1 Static order submission strategies

Problem Type Strategy

Static strategies for liquidity traders

Static strategies for informed traders

3.1.2 Dynamic order submission strategies

3.1.3 Framework for order submission strategy

3. Submit a limit order to transact q shares at a specific limit price pL

3.2 Limit-order execution models

P r(F ullyExecuted|T, O, X) = P r(T T F ≤ T |O, X) (3.7)

P r(P artiallyExecuted|T, O, X) = P r(T T F F ≤ T |O, X) − P r(T T F ≤ T |O, X) (3.8)

P r(U nExecuted|T, O, X) = P r(T T F F > T |O, X) = 1 − P r(T T F F ≤ T |O, X) (3.9)

3.2.1 Execution probability models

ALmtt = AskVt − AskVt−1 , if Askt = Askt−1

ALmtt = AskVt , if Askt < Askt−1

3.2.2 Execution time models

First-passage time models

F P T (∆) ≤ T T F F (∆) ≤ T T F (∆) ≤ F P T (∆ + ) (3.10)

P r(F ullyExecuted|T, O, X) = P r(T T F ≤ T |O, X) ≈ P r(F P T ≤ T |O, X) (3.11)

Empirical execution time models

4.2 Problem statement

4.3 Expected contributions

1. A literature review of models of limit-order execution in an order driven market.

3. Analysis of determinants and dynamic of the execution probability.

4.4 Scope of the research

4.5 Validation of contributions

5.1 Tools for real-time data collection

5.2 Simulation models of pure limit order book markets

5.3 Platform for algorithmic trading system development

5.4 Computational model of limit-order execution

5.5 Order submission strategy

Figure 5.1: Timetable of this research

6.1 Banking science virtual trading platform

Figure 6.1: Overview of Banking Science Virtual Trading Platform

6.2 Empirical distribution of execution probability

Table 6.1: Number of students in each component

Execution Probability(Ok ,t,historial data)

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F P T (∆) ≤ T T F F (∆) ≤ T T F (∆) ≤ F P T (∆ + ) (3.10)