Academic journal article Financial Management

Does Order Flow Commonality Extend across Trade Sizes and Securities?

Academic journal article Financial Management

Does Order Flow Commonality Extend across Trade Sizes and Securities?

Article excerpt

We examine commonality in order imbalances across different types of securities and find that the extent of commonality is greater than previously documented. Order imbalances in portfolios of small stocks, large stocks, and closed-end funds have explanatory power for other portfolio returns even in the presence of own order flow. Our analysis of order flow composition reveals commonality in small and medium trades, but not in large trades, across portfolios. The activity from small-size trades is systemic, but not generally associated with returns on other securities. Order imbalances from larger size trades provide more information relevant to stock prices.

**********

Asset pricing models such as the CAPM and its multifactor extensions conclude that systemic factors affect asset returns. Recent studies of large stocks show that order imbalances, which are defined as the differences between buy and sell orders, are correlated across securities. Consistent with systemic trading activity providing information about market factors, Hasbrouck and Seppi (2001) show that the order imbalance in other stocks is an economically significant determinant of the intraday return on a stock even in the presence of the stock's own order imbalance. Chordia, Roll, and Subrahmanyam (2002) extend this research by providing evidence that daily market returns are strongly affected by contemporaneous order imbalances. Harford and Kaul (2005) provide evidence that indexing is a primary source of correlated order flow.

Studies that examine systemic trading activity generally limit or weight their analyses to the largest, most frequently traded stocks. Yet, there are several reasons why systemic trading activity may vary with firm size. First, feedback trading, which occurs when investors act on simplistic extrapolations of returns, may generate systemic trading that varies across firms. Lakonishok, Shleifer, and Vishny (1992) find that institutions engage in more herding and feedback trading for small stocks than large stocks. Second, noise trader models assume that sentiment motivates trading activity (De Long, Shleifer, Summers, and Waldmann, 1990; Lee, Shleifer, and Thaler, 1991). If retail investors are sentiment-motivated noise traders, then trading activity may vary cross-sectionally according to firm size, as retail investors participate more in the trading activity of small capitalization securities. Recent research supports the view that retail investors act differently than institutional investors (Dennis and Strickland, 2002; Cohen, Gompers, and Vuolteenaho, 2002; Grinblatt and Keloharju, 2000). Third, Lo and Wang (2000) show that if asset prices are related to factor structures, portfolio separation implies that turnover has an approximate linear factor structure; they provide empirical evidence that cross-sectional variation in turnover is related to firm size.

Since research shows that trading activity varies with market capitalization, we extend the research on order flow commonality in large stocks. In our investigation, we examine three issues. First, our study investigates the pervasiveness of order flow commonality across different types of securities. In contrast to large capitalization stocks, the trading in small stocks and closed-end funds is dominated by retail investors. Another reason why we examine closed-end funds is that the fundamental values of these securities are relatively transparent. As the market values of closed-end fund portfolios are released regularly, investors have less asymmetric information about the value of these funds than shares in a regular company. Trading activity in closed-end funds is more likely to be driven by macroeconomic and sentiment factors than private information. We find positive correlations between order imbalances for portfolios of all three security types. Our results suggest that systemic trading activity is broader than documented in prior studies. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.