The Adaptive Nature of Liquidity Taking in Limit Order Books

40 Pages Posted: 5 Mar 2014 Last revised: 26 Apr 2016

See all articles by Damian Taranto

Damian Taranto

Scuola Normale Superiore

Giacomo Bormetti

University of Bologna - Department of Mathematics

Fabrizio Lillo

Università di Bologna

Date Written: March 4, 2014

Abstract

In financial markets, the order flow, defined as the process assuming value one for buy market orders and minus one for sell market orders, displays a very slowly decaying autocorrelation function. Since orders impact prices, reconciling the persistence of the order flow with market efficiency is a subtle issue. A possible solution is provided by asymmetric liquidity, which states that the impact of a buy or sell order is inversely related to the probability of its occurrence. We empirically find that when the order flow predictability increases in one direction, the liquidity in the opposite side decreases, but the probability that a trade moves the price decreases significantly. While the last mechanism is able to counterbalance the persistence of order flow and restore efficiency and diffusivity, the first acts in opposite direction. We introduce a statistical order book model where the persistence of the order flow is mitigated by adjusting the market order volume to the predictability of the order flow. The model reproduces the diffusive behaviour of prices at all time scales without fine-tuning the values of parameters, as well as the behaviour of most order book quantities as a function of the local predictability of order flow.

Keywords: Financial markets, market microstructure, limit order book, liquidity

JEL Classification: C1, G1

Suggested Citation

Taranto, Damian and Bormetti, Giacomo and Lillo, Fabrizio, The Adaptive Nature of Liquidity Taking in Limit Order Books (March 4, 2014). Available at SSRN: https://ssrn.com/abstract=2404405 or http://dx.doi.org/10.2139/ssrn.2404405

Damian Taranto

Scuola Normale Superiore ( email )

Piazza dei Cavalieri, 7
Pisa, 56126
Italy

Giacomo Bormetti (Contact Author)

University of Bologna - Department of Mathematics ( email )

Piazza di Porta S. Donato , 5
Bologna, Bologna 40126
Italy

Fabrizio Lillo

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126
Italy

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