Correlated Order Flow: Pervasiveness, Sources, and Pricing Effects

Abstract:     
We hypothesize that a combination of indexing, industry and broader market forces create common effects in order flow and returns. We test the relative contribution of each to common effects in large samples of both index and non-index stocks. Common effects are strong in index constituent stocks, but are economically inconsequential in non-index stocks. Once indexing effects have been removed, the common effects in index constituents disappear. Industry and broader market effects exist, but contribute relatively little to common effects. Aside from identifying economic causes for the statistical common factors extracted in prior work, these results indicate that common effects are not pervasive. Finally, we show that common effects in order flow have real economic impact by linking them to common effects in returns. This effect of order flow on the correlation structure of returns has implications for diversification strategies. The results also show that specialists adjust prices differentially in the presence of aggregate order flow, supporting multi-asset models of price formation and suggesting that traders with discretion can minimize the price impact of their trades by timing these to coincide with index trading.

Number of Pages in PDF File: 43

working papers series