Large stock price changes: volume or liquidity?

We analyse large stock price changes of more than five standard deviations for (i) TAQ data for the year 1997 and (ii) order book data from the Island ECN for the year 2002. We argue that a large trading volume alone is not a sufficient explanation for large price changes. Instead, we find that a low density of limit orders in the order book, i.e. a small liquidity, is a necessary prerequisite for the occurrence of extreme price fluctuations. Taking into account both order flow and liquidity, large stock price fluctuations can be explained quantitatively.

[1]  T. Andersen.  THE ECONOMETRICS OF FINANCIAL MARKETS , 1998, Econometric Theory.

[2]  A. Lo,et al.  An Ordered Probit Analysis of Transaction Stock Prices , 1991 .

[3]  P. Gopikrishnan,et al.  Inverse cubic law for the distribution of stock price variations , 1998, cond-mat/9803374.

[4]  Joel Hasbrouck,et al.  Measuring the Information Content of Stock Trades , 1991 .

[5]  J. Bouchaud,et al.  Fluctuations and Response in Financial Markets: The Subtle Nature of 'Random' Price Changes , 2003, cond-mat/0307332.

[6]  S. Viswanathan,et al.  Variations in Trading Volume, Return Volatility, and Trading Costs: Evidence on Recent Price Formation Models , 1993 .

[7]  Ian Domowitz,et al.  Liquidity in an Automated Auction , 2001 .

[8]  V. Plerou,et al.  A theory of power-law distributions in financial market fluctuations , 2003, Nature.

[9]  Pierre Giot,et al.  How Does Liquidity React to Stress Periods in a Limit Order Market? , 2004 .

[10]  Bernd Rosenow.  FLUCTUATIONS AND MARKET FRICTION IN FINANCIAL TRADING , 2002 .

[11]  Xavier Gabaix,et al.  Quantifying stock-price response to demand fluctuations. , 2002, Physical review. E, Statistical, nonlinear, and soft matter physics.

[12]  Avanidhar Subrahmanyam,et al.  Market Liquidity and Trading Activity , 2000 .

[13]  F. Lillo,et al.  The Long Memory of the Efficient Market , 2003, cond-mat/0311053.

[14]  B. Mandlebrot.  The Variation of Certain Speculative Prices , 1963 .

[15]  F. Lillo,et al.  Econophysics: Master curve for price-impact function , 2003, Nature.

[16]  F. Lillo,et al.  What really causes large price changes? , 2003, cond-mat/0312703.

[17]  Martin D. D. Evans,et al.  Order Flow and Exchange Rate Dynamics , 1999, Journal of Political Economy.

[18]  B. Rosenow,et al.  Order book approach to price impact , 2003, cond-mat/0311457.

[19]  Jean-Philippe Bouchaud,et al.  More Statistical Properties of Order Books and Price Impact , 2002, cond-mat/0210710.

[20]  A. Kyle.  Continuous Auctions and Insider Trading , 1985 .

[21]  Ananth N. Madhavan,et al.  Why Do Security Prices Change? A Transaction-Level Analysis of Nyse Stocks , 1996 .

[22]  Thomas Lux,et al.  The stable Paretian hypothesis and the frequency of large returns: an examination of major German stocks , 1996 .

[23]  Hideki Takayasu,et al.  Empirical Science of Financial Fluctuations , 2002 .

[24]  F. Lillo,et al.  On the origin of power-law tails in price fluctuations , 2003, cond-mat/0309416.

[25]  Charles M. C. Lee,et al.  Inferring Trade Direction from Intraday Data , 1991 .

[26]  Olaf Korn,et al.  Market Depth and Order Size , 1999 .

[27]  L. Glosten.  Is the Electronic Open Limit Order Book Inevitable , 1994 .

[28]  Patrik Sand̊as,et al.  Adverse Selection and Competitive Market Making: Empirical Evidence from a Limit Order Market , 2001 .

[29]  Lawrence Harris,et al.  Estimating the components of the bid/ask spread , 1988 .

[30]  P. Phillips,et al.  Testing the covariance stationarity of heavy-tailed time series: An overview of the theory with applications to several financial datasets , 1994 .

[31]  Stanley,et al.  Statistical properties of share volume traded in financial markets , 2000, Physical review. E, Statistical physics, plasmas, fluids, and related interdisciplinary topics.

[32]  H. Eugene Stanley,et al.  Inverse Cubic Law for the Probability Distribution of Stock Price Variations , 1998 .