Market Impact with Autocorrelated Order Flow under Perfect Competition

TL;DR

This paper models market impact considering autocorrelated order flow under perfect competition, explaining empirical phenomena and deriving relationships between order flow, impact, and price dynamics to improve trading strategies.

Contribution

It introduces a comprehensive model linking autocorrelated order flow with market impact, providing new insights into price behavior and optimal liquidation strategies under perfect competition.

Findings

Market impact functions depend on order flow correlations.

Prices can be martingales despite autocorrelation in order flow.

Impact decay can inform better liquidation strategies.

Abstract

Our goal in this paper is to study the market impact in a market in which the order flow is autocorrelated. We build a model which explains qualitatively and quantitatively the empirical facts observed so far concerning market impact. We define different notions of market impact, and show how they lead to the different price paths observed in the literature. For each one, under the assumption of perfect competition and information, we derive and explain the relationships between the correlations in the order flow, the shape of the market impact function while a meta-order is being executed, and the expected price after the completion. We also derive an expression for the decay of market impact after a trade, and show how it can result in a better liquidation strategy for an informed trader. We show how, in spite of auto-correlation in order-flow, prices can be martingales, and how price manipulation is ruled out even though the bare impact function is concave. We finally assess the cost of market impact and try to make a step towards optimal strategies.