Effect of order flow imbalance on market impact across market states

Abstract

Every time a trader places an order to buy or sell a stock, this order causes reactions that change the market in highly complex ways. In theory these changes are always detrimental to the trader, causing the stock to become more expensive when buying and cheaper when selling. For large hedge funds, these costs have the potential to become a major obstruction to profitability when aggregated. Market impact models have been based on simple supply and demand, no arbitrage theory, and Brownian motion. These previous models have shown that the market impact of orders and trades can be largely explained using a linear model with Order Flow Imbalance (OFI), a simple measure of the buy/sell imbalance of quote orders placed to the National Best Bid and Offer (NBBO) in a window of time, as the sole predictor. By examining this relationship between OFI and price movement, previous studies have derived observable measures for the market impact of orders placed in a period of time, however these models are unsurprisingly noisy. Using a simple Brownian motion model for the movement of prices, we propose a new method for observing this price impact and compare it to previously accepted models. We then use this measure to examine how price impact varies across market states (i.e. volume, time of day, and spread).