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Exploiting Stock Limit Order Books?

Posted in Technical Trading

Do stock limit order books tip the direction of stock price? In their October 2015 paper entitled “Enhancing Trading Strategies with Order Book Signals”, Alvaro Cartea, Ryan Donnelly and Sebastian Jaimungal test the use of buying and selling pressures based on limit order book data to predict the direction, depth and magnitude of near-term stock price movements. They define pressure simply as the difference between the volume of limit orders at the highest bid minus volume of limit orders at the lowest ask, divided by the sum of the two volumes. When the ratio approaches 1 (-1), there is strong buying (selling) pressure. They test the degree to which traders can enhance performance of round-trip trading strategies by exploiting buying and selling pressure. Using stock limit order book data for ten Nasdaq stocks with relatively large tick sizes during January 2014 through June 2014 to calibrate trading rules and during July 2014 through December 2014 to test application of the rules to trading, they find that:

  • Buying/selling pressure strongly predicts the volume, direction of return and magnitude of return for near-term market orders. Strong buying (selling) pressure indicates a high probability that the next market order is buy (sell) order and that near-term returns are positive (negative) and material.
  • Exploiting buying/selling pressure to optimize round-trip trading strategies boosts profitability by reducing adverse selection costs and exploiting favorable price movements. Also, the tighter the control on inventory age, the more profitable the strategy.
    • For ten Nasdaq stocks with relatively large ticks, Sharpe ratios for naive limit order attempts to capture the lowest-ask/highest-bid spread are negative.
    • In contrast, Sharpe ratios are positive when using limit orders informed by buying/selling pressure.

In summary, evidence suggests that stock traders employing strategies with frequent round trips may be able to boost performance by exploiting buying/selling pressure as exposed in limit order books to improve entries and exits.

Cautions regarding findings include:

  • Calculations are gross of transaction fees, which would reduce profitability in all tests.
  • The approach described involves fast data acquisition/processing (limit order books change quickly) that are likely beyond the reach of many traders.
  • Limit order book behaviors during 2014 may not be representative of those in other market liquidity environments.
  • As noted in the paper, the limit order book is susceptible to manipulation by placing and quickly canceling limit orders.
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