Assessing Measures of Order Flow Toxicity and Early Warning Signals for Market Turbulence

Review of Finance, Vol. 19, pp. 1-54, 2015

43 Pages Posted: 12 Jul 2013 Last revised: 6 Apr 2015

See all articles by Torben G. Andersen

Torben G. Andersen

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Aarhus University - CREATES

Oleg Bondarenko

University of Illinois at Chicago - Department of Finance

Date Written: June 17, 2014

Abstract

Following the much publicized "flash crash" in the U.S. financial markets on May 6, 2010, much work has been done in terms of developing reliable warning signals for impending market stress. However, this has met with limited success, except for one measure. The VPIN, or Volume-synchronized Probability of INformed trading, metric is introduced by Easley, Lopez de Prado and O'Hara (ELO) as a real-time indicator of order flow toxicity. They find the measure useful in predicting return volatility and conclude it, indeed, may help signal impending market turmoil. The VPIN metric involves decomposing volume into active buys and sells. We use the best-bid-offer (BBO) files from the CME Group to construct highly accurate trade classification measures for the E-mini S&P 500 futures contract. Against this benchmark, the ELO Bulk Volume Classification (BVC) scheme is inferior to a standard tick rule based on individual transactions. Moreover, when VPIN is constructed from an accurate classification, it behaves in a diametrically opposite way to BVC-VPIN. We also find the latter to have forecast power for volatility solely because it generates systematic classification errors that are correlated with trading volume and return volatility. Controlling for trading intensity and volatility, the BVC-VPIN measure has no incremental predictive power for future volatility. We conclude that VPIN is not suitable for capturing order flow toxicity or signaling ensuing market turbulence.

Keywords: VPIN, Order Flow Toxicity, Order Imbalance, Accuracy of Trade Classification, Volatility Forecasting

JEL Classification: G01, G12, G14, G17, C58

Suggested Citation

Andersen, Torben G. and Bondarenko, Oleg, Assessing Measures of Order Flow Toxicity and Early Warning Signals for Market Turbulence (June 17, 2014). Review of Finance, Vol. 19, pp. 1-54, 2015 , Available at SSRN: https://ssrn.com/abstract=2292602 or http://dx.doi.org/10.2139/ssrn.2292602

Torben G. Andersen

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Aarhus University - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Oleg Bondarenko (Contact Author)

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States
(312) 996-2362 (Phone)
(312) 413-7948 (Fax)

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