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

See all articles by David Easley

David Easley

Cornell University - Department of Economics; Cornell University - Department of Information Science

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management; Cornell SC Johnson College of Business

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 López de Prado, Marcos and López 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)

Cornell University - Department of Information Science ( email )

402 Bill & Melinda Gates Hall
Ithaca, NY 14853
United States

Marcos López de Prado

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

HOME PAGE: http://www.adia.ae

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

True Positive Technologies ( email )

NY
United States

HOME PAGE: http://www.truepositive.com

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)

Cornell SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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