23 Pages Posted: 26 Sep 2008 Last revised: 31 Aug 2009
Date Written: September 24, 2008
We propose a stochastic model for the continuous-time dynamics of a limit order book. The model strikes a balance between three desirable features: it can be estimated easily from data, it captures key empirical properties of order book dynamics and its analytical tractability allows for fast computation of various quantities of interest without resorting to simulation. We describe a simple parameter estimation procedure based on high-frequency observations of the order book and illustrate the results on data from the Tokyo stock exchange. Using Laplace transform methods, we are able to efficiently compute probabilities of various events, conditional on the state of the order book: an increase in the mid-price, execution of an order at the bid before the ask quote moves, and execution of both a buy and a sell order at the best quotes before the price moves. Using high-frequency data, we show that our model can effectively capture the short-term dynamics of a limit order book. We also evaluate the performance of a simple trading strategy that is based on our results.
Keywords: High frequency data, limit order book, financial engineering, Laplace transform
JEL Classification: C44, C51, C32
Suggested Citation: Suggested Citation
Cont, Rama and Stoikov, Sasha and Talreja, Rishi, A Stochastic Model for Order Book Dynamics (September 24, 2008). Available at SSRN: https://ssrn.com/abstract=1273160 or http://dx.doi.org/10.2139/ssrn.1273160
By Rama Cont