Market microstructure: Limit orders and order flow

One of my favourite post crisis themes has been the idea that market microstructure has macro consequences. I touch upon this in my paper on post crisis finance (mentioned in my blog posts here and here). Two papers that I read last month are related to this theme.

Psy-Fi blog pointed me towards a paper by Linnainmaa showing that the under performance of individual investors’ portfolios can be attributed largely to their use of limit orders. When one looks at trades, it may appear that these investors were stupidly selling when the smart money was buying in response to good news. Linnainmaa’s point is that quite often, this apparent “selling” is not really active selling; their limit orders were simply being hit by the smart money. Looking at the totality of the orders of individual orders may show that these orders had no sell bias. What happens is that when the smart money is buying, the individual investors’ buy limit orders do not execute while their sell orders do.

If this is true, then one implication of this use of limit orders by uninformed traders is that the smart money is able to buy shares too cheap. The price does not move as much as it should have. This phenomenon may also be contributing to the well known momentum effect. This leads straight on to the second paper that I read recently (I do not recall to whom I owe a hat tip for this paper).

Beber, Brandt and Kavajecz published their paper “What Does Equity Sector Orderflow Tell Us About the Economy?” recently (the working paper version is available here). They not only show that the order flow into defensive sectors of the stock market forecasts recessions, but they go on to show that the order flow does a better job than prices or returns. One possible explanation of why order flow is more informative than prices is of course the phenomenon described by Linnainmaa – since uninformed limit orders absorb some of the impact of informed buying, the full information of these orders is not impounded in prices..

This is of course totally different from genuine equilibrium models with representative agents where prices are not only fully informative but also move with zero trading volume implying that order flows and trading volumes are totally uninformative (or rather totally irrelevant).

Posted at 9:49 pm IST on Sun, 5 Feb 2012         permanent link

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