What really causes large price changes?
J. Doyne Farmer, Laszlo Gillemot, Fabrizio Lillo, Szabolcs Mike,, Anindya Sen

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…
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Taxonomy
TopicsFinancial Markets and Investment Strategies · Complex Systems and Time Series Analysis · Market Dynamics and Volatility
