The Exchange of Flow Toxicity

The Journal of Trading, Vol. 6, No. 2, pp. 8-13, Spring 2011

Johnson School Research Paper Series No. 10-2011

12 Pages Posted: 27 Jan 2011 Last revised: 27 Feb 2012

See all articles by David Easley

David Easley

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

Marcos Lopez de Prado

AQR Capital Management, LLC; Cornell University - Operations Research & Industrial Engineering; RCC - Harvard University

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: January 17, 2011

Abstract

Flow toxicity can be measured in terms of the probability that a liquidity provider is adversely selected by informed traders. In previous papers we introduced the concept of Volume-synchronized Probability of Informed Trading (the VPIN* metric), and provided a robust estimation procedure. In this study, we discuss the asymmetric impact that an incorrect estimation of the VPIN metric has on a market maker’s performance. This asymmetry may be part of the explanation for the evaporation of liquidity witnessed on May 6th 2010. To mitigate that undesirable behavior, we present the specifications of a VPIN contract, which could be used to hedge against the risk of higher than expected levels of toxicity, as well as to monitor such risk. Among other applications, it would also work as an execution benchmark, and a price discovery mechanism, since it allows for the externalization of market participants’ views of future toxicity.

Keywords: Liquidity Provision, Flow Toxicity, Market Microstructure, VPIN

JEL Classification: C51, C53, G10, G12, G14

Suggested Citation

Easley, David and López de Prado, Marcos and O'Hara, Maureen, The Exchange of Flow Toxicity (January 17, 2011). The Journal of Trading, Vol. 6, No. 2, pp. 8-13, Spring 2011; Johnson School Research Paper Series No. 10-2011. Available at SSRN: https://ssrn.com/abstract=1748633 or http://dx.doi.org/10.2139/ssrn.1748633

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

AQR Capital Management, LLC ( email )

One Greenwich Plaza
Greenwich, CT 06830
United States

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

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

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

RCC - Harvard University ( email )

1875 Cambridge 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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