Flow Toxicity and Liquidity in a High Frequency World
Cornell University - Department of Economics
Marcos Lopez de Prado
Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC
Cornell University - Samuel Curtis Johnson Graduate School of Management
February 20, 2012
Review of Financial Studies, Vol. 25, No. 5, pp. 1457-1493, 2012.
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.
Number of Pages in PDF File: 71
Keywords: Flash crash, liquidity, flow toxicity, volume imbalance, market microstructure, probability of informed trading, VPIN
JEL Classification: C02, D52, D53, G14
Date posted: October 23, 2010 ; Last revised: April 15, 2012