The Accuracy of Trade Classification Rules: Evidence from Nasdaq
Cornell University - Samuel Curtis Johnson Graduate School of Management
Government of the Commonwealth of Australia - Australian Prudential Regulation Authority (APRA)
Johnson@Cornell Tech, Cornell University; Interdisciplinary Center (IDC)
Journal of Financial and Quantitative Analysis, December 2000
Researchers are increasingly using data from the Nasdaq market to examine pricing behavior, market design, and other microstructure phenomena. The validity of any study that classifies trades as buys or sells depends on the accuracy of the classification method. Using a Nasdaq proprietary data set that identifies trade direction, we examine the validity of several trade classification algorithms. We find that the quote rule, the tick rule, and the Lee and Ready (1991) rule correctly classify 76.4%, 77.66%, and 81.05% of the trades, respectively. However, all classification rules have only a very limited success in classifying trades executed inside the quotes, introducing a bias in the accuracy of classifying large trades, trades during high volume periods, and ECN trades. We also find that extant algorithms do a mediocre job when used for calculating effective spreads. For Nasdaq trades, we propose a new and simple classification algorithm that improves over extant algorithms.
Date posted: February 19, 2001