How do Extreme Price Movements End?

Abstract

We test competing theories on liquidity dynamics during extreme price movements (EPMs). Our findings indicate that market makers strategically allow for price pressures and earn compensation from pricing errors. As a result, liquidity provision intensifies towards the end of an average EPM. This goes counter to a widespread concern that market making constraints cause the deterioration of liquidity as EPMs develop. Finally, we demonstrate that limit order book dynamics during EPMs is in line with a socially beneficial equilibrium.

Keywords: extreme price movements, price pressures, strategic liquidity provision

JEL Classification: G10, G14