Order-Flow Filtration and Directional Association with Short-Horizon Returns

TL;DR

This paper investigates how simple structural filters on order flow improve the association between order book imbalance and short-term returns, especially when applied to parent orders, using data from Indian futures markets.

Contribution

It demonstrates that filtering parent orders enhances the predictive power of order book imbalance for short-horizon returns in emerging markets.

Findings

Filtering parent orders strengthens OBI-return association.

Unfiltered order flow shows modest improvements after filtering.

Filtered OBI on parent orders better reflects market quality.

Abstract

Electronic markets generate dense order flow with many transient orders, which degrade directional signals derived from the limit order book (LOB). We study whether simple structural filters on order lifetime, modification count, and modification timing sharpen the association between order book imbalance (OBI) and short-horizon returns in BankNifty index futures, where unfiltered OBI is already known to be a strong short-horizon directional indicator. The efficacy of each filter is evaluated using a three-step diagnostic ladder: contemporaneous correlations, linear association between discretised regimes, and Hawkes event-time excitation between OBI and return regimes. Our results indicate that filtration of the aggregate order flow produces only modest changes relative to the unfiltered benchmark. By contrast, when filters are applied on the parent orders of executed trades, the resulting OBI series exhibits systematically stronger directional association. Motivated by recent regulatory initiatives to curb noisy order flow, we treat the association between OBI and short-horizon returns as a policy-relevant diagnostic of market quality. We then compare unfiltered and filtered OBI series, using tick-by-tick data from the National Stock Exchange of India, to infer how structural filters on the order flow affect OBI-return dynamics in an emerging market setting.