RESEARCH

We emphasize and encourage links between academic researchers and practitioners at financial institutions to bring theoretical techniques to bear on realworld issues.

ABSTRACT

ABSTRACT

We use high-frequency data from the Nasdaq exchange to build a measure of volume imbalance in the limit order book (LOB). We show that our measure is a good predictor of the sign of the next market order (MO), i.e. buy or sell, and also helps to predict price changes immediately after the arrival of an MO. Based on these empirical findings, we introduce and calibrate a Markov chain modulated pure jump model of price, spread, LO and MO arrivals, and volume imbalance. As an application of the model, we pose and solve a stochastic control problem for an agent who maximizes terminal wealth, subject to inventory penalties, by executing trades using LOs. We use in-sample-data (January to June 2014) to calibrate the model to ten equities traded in the Nasdaq exchange, and use out-of-sample data (July to December 2014) to test the performance of the strategy. We show that introducing our volume imbalance measure into the optimization problem considerably boosts the profits of the strategy. Profits increase because employing our imbalance measure reduces adverse selection costs and positions LOs in the book to take advantage of favorable price movements.


SSRN-id2668277-1.pdf


 

AUTHORS

AUTHORS

Alvaro Carteaa
University of Oxford, Oxford, United Kingdom
Ryan Donnellyb
Ecole Polytechnique F´ed´erale de Lausanne (EPFL), Lausanne, Switzerland
Sebastian Jaimungalc
University of Toronto, Toronto, Canada