Abstract:
Order flow is regarded as toxic when it adversely selects market makers, who may be unaware that they are providing liquidity at a loss. Flow toxicity can be expressed in by the Probability of Informed Trading (PIN). We present a new procedure to estimate the Probability of Informed Trading based on volume imbalance (the VPIN* informed trading metric). An important advantage of the VPIN metric over previous estimation procedures is that it does not require the intermediate estimation of non-observable parameters describing the order flow or the application of numerical methods. An additional advantage is that VPIN is updated in volume-time, rather than clock-time, which improves its predictive power in a high frequency world. Monte Carlo experiments show that our estimate is accurate for all theoretically possible combinations of parameters. Finally, we show that the VPIN metric predicts short-term future volatility.

Easley, David, Lopez de Prado, Marcos M. and O’Hara, Maureen, Flow Toxicity and Volatility in a High Frequency World (February 25, 2011). Johnson School Research Paper Series No. 9-2011. Available at SSRN: http://ssrn.com/abstract=1695596

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