Overestimated Effective Spreads: Implications for Investors
59 Pages Posted: 23 Mar 2017 Last revised: 3 Jun 2017
Date Written: March 23, 2017
I show that the effective spread measured relative to the spread midpoint overstates the theoretical effective spread in markets with discrete prices and elastic liquidity demand. The average overestimation is 16% for S&P 500 stocks in general, and 60% for stocks with high relative tick size. The overestimation increases with price discreteness and maker fees. I propose an alternative measure that overcomes the overestimation problem: the microprice effective spread. Investors using the microprice effective spread are better positioned to minimize illiquidity costs through liquidity timing and order routing, evaluate adverse selection, and optimize their portfolio weights and rebalancing frequency.
Keywords: midpoint, microprice, liquidity demand elasticity, liquidity, illiquidity, Rule 605, NBBO, TRTH
JEL Classification: C15, G12, G20
Suggested Citation: Suggested Citation