Order-Flow and Liquidity Provision

Abstract

We show how to optimally take positions in the limit order book by placing limit orders at-the-touch when the midprice of the asset is affected by the trading activity of the market. The midprice dynamics have a short-term-alpha component which reflects how instantaneous net order-flow, the difference between the number of market buy and market sell orders, affects the asset's drift. If net-order flow is positive (negative), so short-term-alpha is positive (negative), the strategy may even withdraw from the sell (buy) side of the limit order book to take advantage of inventory appreciation (depreciation) and to protect the trading strategy from adverse selection costs.

Keywords: Algorithmic Trading, High Frequency Trading, Market Making, Short Term Alpha, Adverse Selection, Order Flow