Liquidity, Information, and Infrequently Traded Stocks
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What they found
The authors introduced PIN, the probability of informed trading, estimated from the daily pattern of buy and sell orders. On a model where information events occur randomly and informed traders trade only on those days, they estimate the parameters from order imbalances for NYSE stocks and find that infrequently traded stocks have a higher probability of informed trading and therefore wider spreads. The paper links market-maker behavior directly to the estimated risk of trading against someone who knows more.
What you can use
- Order imbalances contain information about whether informed traders are active; unusually one-sided flow is a warning sign.
- Thinly traded stocks carry a higher risk of informed counterparties, which explains their wide spreads.
- The intuition behind PIN is the ancestor of modern order-flow toxicity measures used by market makers.
Caveats
The PIN model has known estimation problems and has been criticized for producing biased estimates in active stocks. Daily-frequency data from 1990.
Tags: microstructure, informed-trading, order-flow, pin
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.