The Price Impact of Order Book Events

TL;DR

This paper investigates how order book events influence short-term price changes, demonstrating a linear relationship with order flow imbalance that explains the square-root volume-price relation.

Contribution

It introduces a linear price impact model based on order flow imbalance, showing its robustness and explaining the volume-price relation in financial markets.

Findings

Price changes are mainly driven by order flow imbalance.

A linear relation exists between order flow imbalance and price changes.

The model explains the square-root relation between price changes and trading volume.

Abstract

We study the price impact of order book events - limit orders, market orders and cancelations - using the NYSE TAQ data for 50 U.S. stocks. We show that, over short time intervals, price changes are mainly driven by the order flow imbalance, defined as the imbalance between supply and demand at the best bid and ask prices. Our study reveals a linear relation between order flow imbalance and price changes, with a slope inversely proportional to the market depth. These results are shown to be robust to seasonality effects, and stable across time scales and across stocks. We argue that this linear price impact model, together with a scaling argument, implies the empirically observed "square-root" relation between price changes and trading volume. However, the relation between price changes and trade volume is found to be noisy and less robust than the one based on order flow imbalance.