On the occurrence and consequences of inaccurate trade classification

Abstract The validity of many economic studies hinges on the ability to properly classify trades as buyer or seller-initiated. This study uses the TORQ data to investigate the performance of the Lee and Ready (1991, Journal of Finance 46, 733–746.) trade classification algorithm. I find that the algorithm correctly classifies 85% of the transactions in my sample, but systematically misclassifies transactions at the midpoint of the bid–ask spread, small transactions, and transactions in large or frequently traded stocks. I then provide evidence of the biases induced by inaccurate trade classification.