Asymmetric Effects of the Limit Order Book on Price Dynamics

Abstract

The objective of this paper is to analyze how the information embedded in different parts of the limit order book (LOB) affects price dynamics. We distinguish between slopes of lower and higher levels of the bid and ask sides and include them in a linear vector autoregressive system, along with the midquote return and trade direction, as in Hasbrouck (1991). The slopes of the higher levels have significantly greater (in terms of absolute value) immediate effects on prices than do the corresponding slopes of the lower levels. The immediate effects of the slope variable are reversed when we take the cumulative effects into consideration, suggesting that prices overreact to information embedded in the LOB. Furthermore, this reversal is stronger for the higher levels than for the lower levels, resulting in the cumulative effects of the higher levels being smaller than those of the lower levels. We link the asymmetries in the immediate effects of the lower and higher levels to the existence of more patient traders, in line with recent theoretical findings. Finally, we show that ignoring these asymmetries might have cost a high-frequency day trader 16 to 25 basis points in monthly profits.

Keywords: Limit order book slope, Hasbrouck model, High-frequency trading, Asymmetric price impact, Patient traders.

JEL Classification: G10, G14, G19