Real-Time Detection of Volatility in Liquidity Provision
Applied Finance Letters Forthcoming
16 Pages Posted: 27 Jan 2021
Date Written: November 5, 2020
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: Suggested Citation