Flow Toxicity and Liquidity in a High Frequency World

Review of Financial Studies, Vol. 25, No. 5, pp. 1457-1493, 2012.

71 Pages Posted: 23 Oct 2010 Last revised: 15 Apr 2012

David Easley

Cornell University - Department of Economics

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: February 20, 2012

Abstract

Order flow is toxic when it adversely selects market makers, who may be unaware they are providing liquidity at a loss. We present a new procedure to estimate flow toxicity based on volume imbalance and trade intensity (the VPIN toxicity metric). VPIN is updated in volume-time, making it applicable to the high frequency world, and it does not require the intermediate estimation of non-observable parameters or the application of numerical methods. It does require trades classified as buys or sells, and we develop a new bulk volume classification procedure that we argue is more useful in high frequency markets than standard classification procedures. We show that the VPIN metric is a useful indicator of short-term, toxicity-induced volatility.

Keywords: Flash crash, liquidity, flow toxicity, volume imbalance, market microstructure, probability of informed trading, VPIN

JEL Classification: C02, D52, D53, G14

Suggested Citation

Easley, David and Lopez de Prado, Marcos and O'Hara, Maureen, Flow Toxicity and Liquidity in a High Frequency World (February 20, 2012). Review of Financial Studies, Vol. 25, No. 5, pp. 1457-1493, 2012.. Available at SSRN: https://ssrn.com/abstract=1695596 or http://dx.doi.org/10.2139/ssrn.1695596

David Easley (Contact Author)

Cornell University - Department of Economics ( email )

414 Uris Hall
Ithaca, NY 14853-7601
United States
607-255-6283 (Phone)
607-255-2818 (Fax)

Marcos Lopez de Prado

Guggenheim Partners, LLC ( email )

330 Madison Avenue
New York, NY 10017
United States

HOME PAGE: http://www.QuantResearch.org

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.lbl.gov

Harvard University - RCC ( email )

26 Trowbridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-255-3645 (Phone)
607-255-5993 (Fax)

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