The Information Content of a Limit Order Book: The Case of an FX Market

Abstract:     
In this paper we examine the question of whether knowledge of the information contained in a limit order book helps to provide economic value in a simple trading scheme. Given the greater information content of the order book, over simple price information, it might naturally be expected that the order book would dominate. The literature however is divided and it is still an open question as to whether the order book adds value. We find that despite the statistical significance of variables describing the structure of the limit order book in explaining tick by tick returns, they do not consistently add significant economic value. We show this using a simple linear model to determine trading activity as well as a model free genetic algorithm based on price, order flow and order book information. Using Dollar Sterling tick data we find that the greater transparency provided by knowledge of the structure of the limit order book does not translate into greater profitability beyond that provided by price information alone. We also find that the profitability of all trading rules based on genetic algorithms dropped substantially in 2008 compared to the 2003 data.

Number of Pages in PDF File: 44

Keywords: limit order book, profitability, high-frequency data

JEL Classification: D81, F31, C53

working papers series