Real-Time Detection of Volatility in Liquidity Provision

Applied Finance Letters Forthcoming

16 Pages Posted: 27 Jan 2021

Date Written: November 5, 2020

Abstract

Previous research has found that high-frequency traders will vary the bid or offer price rapidly over periods of milliseconds. This is a benefit to fast traders who can time their trades with microsecond precision, however it is a cost to the average market participant due to increased trade execution price uncertainty. In this analysis we attempt to construct real-time methods for determining whether the liquidity of a security is being altered rapidly. We find a four-state Markov switching model identifies a state where liquidity is being rapidly varied about a mean value. This state can be used to generate a signal to delay market participant orders until the price volatility subsides. Over our sample, the signal would delay orders, in aggregate, over 0 to 10% of the trading day. Each individual delay would only last tens of milliseconds, and so would not be noticable by the average market participant.

Keywords: High-Frequency Trading; Liquidity; Markov-Switching Models

JEL Classification: G10; G12; C24; C4

Suggested Citation

Brigida, Matthew, Real-Time Detection of Volatility in Liquidity Provision (November 5, 2020). Applied Finance Letters Forthcoming, Available at SSRN: https://ssrn.com/abstract=3735239

Matthew Brigida (Contact Author)

SUNY Polytechnic Institute ( email )

United States

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