What really causes large price changes?

TL;DR

This paper investigates the microscopic causes of large price fluctuations in the London Stock Exchange, revealing that liquidity gaps in the order book, rather than order volume, drive significant price changes, with risk profiles varying across stocks.

Contribution

It demonstrates that large price changes are primarily caused by liquidity gaps in the order book, not by order size, and highlights the non-universality of risk across different stocks.

Findings

Large price fluctuations are linked to gaps in the order book.

Order volume has little effect on large price changes.

Risk profiles differ significantly between stocks.

Abstract

We study the cause of large fluctuations in prices in the London Stock Exchange. This is done at the microscopic level of individual events, where an event is the placement or cancellation of an order to buy or sell. We show that price fluctuations caused by individual market orders are essentially independent of the volume of orders. Instead, large price fluctuations are driven by liquidity fluctuations, variations in the market's ability to absorb new orders. Even for the most liquid stocks there can be substantial gaps in the order book, corresponding to a block of adjacent price levels containing no quotes. When such a gap exists next to the best price, a new order can remove the best quote, triggering a large midpoint price change. Thus, the distribution of large price changes merely reflects the distribution of gaps in the limit order book. This is a finite size effect, caused by the granularity of order flow: In a market where participants placed many small orders uniformly across prices, such large price fluctuations would not happen. We show that this explains price fluctuations on longer timescales. In addition, we present results suggesting that the risk profile varies from stock to stock, and is not universal: lightly traded stocks tend to have more extreme risks.