Detecting Informed Trading Risk from Undercutting Activity in Limit Order Markets

57 Pages Posted: 2 Feb 2024 Last revised: 17 May 2024

See all articles by Yashar H. Barardehi

Yashar H. Barardehi

Chapman University - The George L. Argyros College of Business and Economics; U.S. Securities and Exchange Commission

Peter Dixon

U.S. Securities and Exchange Commission

Qiyu Liu

U.S. Securities and Exchange Commission

Date Written: January 9, 2024

Abstract

We use abnormal undercutting activity (QIDRes) to measure informed trading risk, reflecting liquidity-providing algorithms competing less to fill marketable orders when adverse selection exposure rises. Despite its simple construction, when examined around information events, QIDRes behaves similarly to existing measures of informed trading intensity/probability whose constructions are complex. QIDRes predicts arrivals and magnitudes of imminent information events. Moreover, episodes of high QIDRes coincide with weaker subsequent price reversals, increased accumulation/covering of short interest, and increased informed institutional trades. QIDRes positively predicts stock returns up to six months forward, especially among stocks with tighter short sale constraints. Since QIDRes is orthogonal to stock liquidity and is not a persistent stock characteristic, we attribute its return predictability to limits to arbitrage.

Keywords: Informed Trading, Undercutting, Asset Pricing, Liquidity, Limits to Arbitrage

JEL Classification: G14

Suggested Citation

Barardehi, Yashar and Dixon, Peter and Liu, Qiyu, Detecting Informed Trading Risk from Undercutting Activity in Limit Order Markets (January 9, 2024). Available at SSRN: https://ssrn.com/abstract=4689334 or http://dx.doi.org/10.2139/ssrn.4689334

Yashar Barardehi (Contact Author)

Chapman University - The George L. Argyros College of Business and Economics ( email )

1 University Drive
Orange, CA 92866
United States

HOME PAGE: http://sites.google.com/site/barardehi/

U.S. Securities and Exchange Commission ( email )

Peter Dixon

U.S. Securities and Exchange Commission ( email )

450 Fifth Street, NW
Washington, DC 20549-1105
United States

Qiyu Liu

U.S. Securities and Exchange Commission ( email )

100 F Street, NE
Washington, DC 20549
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
252
Abstract Views
801
Rank
230,092
PlumX Metrics