Order Imbalance, Liquidity, and Market Returns

Tarun Chordia
Richard Roll
Avanidhar Subrahmanyam

April 12, 2001

Contacts
Chordia Roll Subrahmanyam
Voice: 1-404-727-1620 1-310-825-6118 1-310-825-5355
Fax: 1-404-727-5238 1-310-206-8404 1-310-206-5455
E-mail: [email protected] [email protected] [email protected]
Address: Goizueta Business School Anderson School Anderson School
Emory University UCLA UCLA
Atlanta, GA 30322 Los Angeles, CA 90095-1481 Los Angeles, CA 90095-1481

This paper owes a significant debt to Charles Lee and Mark Ready for developing the
trade signing algorithm. For helpful comments, we owe a debt of gratitude to an
anonymous referee, Hank Bessembinder, Jeff Busee, Clifton Green, Paul Irvine, Jonathan
Karpoff, Olivier Ledoit, Ross Valkanov, and Sunil Wahal.
 Order Imbalance, Liquidity, and Market Returns

Abstract

Traditionally, volume has provided the link between trading activity and returns. We

focus on a hitherto unexplored but intuitive measure of trading activity: the aggregate

daily order imbalance on the New York Stock Exchange. Signed order imbalances

increase (decrease) following market declines (rises), which reveals that investors are

contrarians on aggregate. Order imbalances in either direction, either excess buy or sell

orders, reduce liquidity. Market-wide returns are strongly affected by contemporaneous

and lagged order imbalances. Market-wide returns reverse themselves after high negative

imbalance, large negative return days; the magnitude of this reversal is partially

predictable from the level of the imbalance and return. Even after controlling for

aggregate market volume and liquidity, market returns are affected by order imbalance.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001

 1. Introduction

A large literature has studied the association between trading activity and stock market returns;

(e.g., see Benston and Hagerman, 1974; Gallant, Rossi, and Tauchen, 1992; Hiemstra and Jones,

1994; Lo and Wang, 2000; and also the studies summarized in Karpoff, 1987). Stock trading

volume is also linked inextricably to liquidity (Benston and Hagerman, 1974; Stoll, 1978b). Our

aim here is to shed further light on the tri-partite association among trading activity, liquidity,

and stock market returns using a lengthy and recent set of high frequency data.

In most existing studies, trading activity is measured by volume. But volume alone is absolutely

guaranteed to conceal some important aspects of trading. Consider, for example, a reported

volume of one million shares. At one extreme, this might be a million shares sold to the market

maker while at the other extreme it could be a million shares purchased. Perhaps more typically,

it would be roughly split, about 500,000 shares sold to and 500,000 shares bought from the

market maker. Clearly, each possibility has its own unique implications for prices and liquidity.

Intuition suggests that prices and liquidity should be more strongly affected by more extreme

order imbalances, regardless of volume, for two reasons. First, order imbalances sometimes

signal private information, which should reduce liquidity at least temporarily and could also

move the market price permanently, as also suggested by the well-known Kyle (1985) theory of

price formation. Second, even a random large order imbalance exacerbates the inventory

problem faced by the market maker, who can be expected to respond by changing bid-ask

spreads and revising price quotations. Hence, order imbalances should be important influences

on stock returns and liquidity, conceivably even more important than volume. Indeed, the

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 1

inventory models of Stoll (1978a), Ho and Stoll (1981), and Spiegel and Subrahmanyam (1995)

involve market makers accommodating buying and selling by outside investors, and liquidity as

well as returns are influenced by inventory concerns in this paradigm.

Most existing studies analyze order imbalances around specific events or over short periods of

time. Thus, Sias (1997) analyzes order imbalances in the context of institutional buying and

selling of closed-end funds; Lauterbach and Ben-Zion (1993) and Blume, MacKinlay, and

Terker, (1989) analyze order imbalances around the October 1987 crash; and Lee (1992) does

the same around earnings announcements. Chan and Fong (2000) analyze how order imbalance

changes the contemporaneous relation between stock volatility and volume using data for about

six months. Hasbrouck and Seppi (2001) and Brown, Walsh, and Yuen (1997) study order

imbalances for thirty and twenty stocks, over one and two years, respectively.

A long-term study using order imbalances for a broad cross-section has not been performed

primarily because transactions databases do not identify buyers and sellers. Thus, the

investigator is obliged to undertake an arduous task: assigning hundreds of millions of

transactions to either the buyer-initiated or seller-initiated categories. Happily, assignment

algorithms are available for this purpose.

Our first contribution is to construct a database of estimated market-wide order imbalances for a

comprehensive sample of NYSE stocks during the period 1988-1998 inclusive. Using data from

the Institute for the Study of Security Markets (1988-1992) and the TAQ database provided by

the NYSE, every transaction is assigned using the Lee/Ready (1991) algorithm. 1 Of course,

1
The Lee/Ready algorithm is basically quite simple; a trade is classified as buyer (seller) initiated if it is closer to
the ask (bid) of the prevailing quote. The quote must be at least five seconds old. If the trade is exactly at the mid-
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 2
there is inevitably some assignment error, so the resulting order imbalances are estimates. Yet,

as shown in Lee and Radhakrishna (2000), and Odders-White (2000), the Lee/Ready algorithm is

accurate enough as to not pose serious problems in our large sample study.

Our empirical study focuses in sequence on (1) characterizing properties and determinants of

market-wide daily order imbalances (2) investigating the relation between order imbalance and

an aggregate measure of liquidity, 2 and (3) investigating the extent to which daily stock market

returns are related to order imbalances after controlling for the effects of market liquidity. To

our knowledge, this is the first paper to consider daily order imbalances for a comprehensive

sample of stocks over a long sample period.

For the aggregate market, asymmetric information is not likely to be an issue, and we expect the

inventory paradigm to be more relevant in the interplay between imbalances, liquidity, and

returns. For example, in this paradigm, after a large inventory imbalance, market makers

position their quotes to encourage trading on the other side of the market in order to stabilize

their inventory. This strategy, if successful, will cause a direct relation between past returns and

future order imbalances. Further, in this paradigm, imbalances cause price pressures that have a

direct effect on returns. Finally, increased return fluctuations cause a widening of the bid-ask

spread due to an increase in inventory risk. While the intention of our study is mainly to

examine the relation between imbalances, spreads, and returns from a purely empirical

standpoint, the inventory paradigm serves as the theoretical underpinning of our analysis. As

point of the quote, a “tick test” is used whereby the trade is classified as buyer (seller) initiated if the last price
change prior to the trade is positive (negative.)
2
Liquidity is measured by the daily value-weighted quoted spread associated with each transaction during the day.
The weights are proportional to market capitalization of each stock at the beginning of the calendar year.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 3
we describe below, our results are broadly supportive of the central implications of this paradigm

of price formation.

We find that the daily levels of order imbalances are persistent, though their first differences are

negatively autocorrelated. In addition, there is evidence that aggregate order imbalance is

contrarian; buying activity is more pronounced following market crashes, and selling activity is

more pronounced following market rises. This evidence is consistent with the notion that

temporary inventory imbalances and consequent price pressures are countervailed effectively by

astute traders. 3

Our analysis also indicates that order imbalances are significantly associated with daily changes

in liquidity and with contemporaneous market returns, after controlling for the level of unsigned

trading activity. The latter result underscores the role of excess buying and selling activity, as

opposed to just trading volume, as a determinant of fluctuations in market returns.

In contrast to market returns, we find liquidity is highly predictable not only by its own past

values, but also by past market returns. This result is consistent with the notion that increased

asset price fluctuations cause a decrease in liquidity owing to an increase in inventory risk.

Notwithstanding the daily serial dependence in both order imbalances and liquidity, there is no

evidence they can predict one-day ahead stock market returns. Thus, the aggregate market is

resilient to market microstructure effects; in general, there is no evidence that the effects of

illiquidity and order imbalance on market returns persist beyond a single day. (The S&P 500

3
Harris and Gurel (1986) and Shleifer (1986) document price pressures when stocks are added to the S&P500 index.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 4
return series was selected as the object to be predicted because its unconditional daily serial

correlation was virtually zero during the 1988-1998 sample period and we wanted a difficult

objective.) However, there is evidence that large negative order imbalance, large negative

return days are accompanied by strong reversals, consistent with the block trading literature for

individual stocks (e.g., Kraus and Stoll, 1972), which suggests that large block sells are

accompanied by reversals in stock prices. Our results underscore the point that price pressures

caused by imbalances in inventory are an issue not just for individual stocks, but for the

aggregate market as well. This finding has direct implications for agents wishing to trade a

diversified market portfolio.

Our decision to analyze liquidity, order imbalances, and returns over daily intervals is to some

extent arbitrary (one could have chosen hourly intervals, or for that matter, monthly intervals).

Our justification is, first, the inventory paradigm that motivates our interplay between liquidity,

order imbalances, and returns is most likely to be manifest itself over rather short horizons, i.e.,

daily as opposed to weekly or monthly; and second, higher than daily frequency poses problems

of inter-asset synchronicity which could make it more difficult to detect market-wide relations.

This paper is organized as follows. Section 2 describes the data. Section 3 discusses the

determinants of order imbalance. Section 4 discusses the relation between liquidity and order

imbalances while Section 5 discusses the relation between returns and order imbalances. Section

6 concludes.

2. Data

The S&P500 is our representative stock market index. It was selected because the serial

correlation in its return series is close to zero (its first-order autocorrelation coefficient was

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 5

0.005, p-value=0.78; higher-order coefficients are also close to zero), and we wanted a difficult

object to be predicted. 4 The transactions data sources are the Institute for the Study of Securities

Markets (ISSM) and the New York Stock Exchange TAQ (trades and automated quotations).

The ISSM data cover 1988-1992 inclusive while the TAQ data are for 1993-1998.

2.1 Inclusion Requirements

Stocks are included or excluded during a calendar year depending on the following criteria:

• To be included, a stock had to be present at the beginning and at the end of the year in both

the CRSP and the intraday databases, and in the S&P 500 at the beginning of the year.

• To keep the size of our sample manageable, and also because signing trades for Nasdaq

stocks is problematic (see, e.g., Christie and Schultz, 1999), and also, we include only NYSE

stocks in the calculation of aggregate order imbalance.

• If the firm changed exchanges from Nasdaq to NYSE during the year (no firms switched

from the NYSE to the Nasdaq during our sample period), it was dropped from the sample for

that year.

• Because their trading characteristics might differ from ordinary equities, assets in the

following categories were also expunged: certificates, ADRs, shares of beneficial interest,

units, companies incorporated outside the U.S., Americus Trust components, closed-end

funds, preferred stocks and REITs.

• To avoid the influence of unduly high-priced stocks, if the price at any month-end during the

year was greater than $999, the stock was deleted from the sample for the year.

4
We also performed regressions using value-weighted and equally-weighted order imbalances for all NYSE stocks,
and value-weighted imbalances for NYSE stocks in the top size decile. The results were broadly consistent with
those reported in this paper for the S&P500 index, and are available upon request from the authors.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 6
Given that a stock is included in the sample, its transaction data are included or excluded

according to the following criteria:

• A trade is excluded if it is out of sequence, recorded before the open or after the closing time,

or has special settlement conditions (because it might then be subject to distinct liquidity

considerations).

• Quotes established before the opening of the market or after the close are excluded.

• Negative bid-ask spreads are discarded.

• Only BBO (best bid or offer)-eligible primary market (NYSE) quotes are retained (Chordia,

Roll, and Subrahmanyam, 2001, provide a justification for using only NYSE quotes).

• Following Lee and Ready (1991), any quote less than five seconds prior to the trade is

ignored and the first one at least five seconds prior to the trade is retained.

2.2 Order Imbalance Variables

Each transaction is designated as either buyer-initiated or seller-initiated according to the Lee

and Ready (1991) algorithm. For each stock-day we compute

• OIBNUMt : the number of buyer-initiated less the number of seller-initiated trades on day t.

• OIBSHt : the buyer-initiated shares purchased less the seller-initiated shares sold on day t.

• OIBDOLt : the buyer-initiated dollars paid less the seller-initiated dollars received on day t.

In addition to the order imbalance measures, we also computed the following measures of

trading activity and liquidity:

• QSPRt : the quoted bid-ask spread averaged across all trades on day t.

• NUMTRANSt : the total number of transactions on day t

• $VOLt : the total dollar volume for day t

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 7

From this point, our analysis focuses on the order imbalance, liquidity, and trading activity

measures aggregated in a value-weighted manner over all stocks in our sample each day. (The

value-weights were computed based on market capitalization as of the end of the previous year.)

2.3 Summary Statistics

Table 1, Panel A presents descriptive statistics for market-wide order imbalance measures, and

other measures of liquidity and trading activity used in this study. The mean/standard deviation

ratios are of similar magnitude for all three measures of order imbalance. The average quoted

spread is about 18 cents, and the average number of transactions is about 658. Interestingly, the

order imbalance measures have positive means and medians. This finding relates to the fact that

we sign market orders in our analysis, which suggests that the excess of buy market orders over

sell market orders is accommodated by the limit order book, provided specialists succeed in

maintaining zero inventory levels on average. Since returns have been overwhelmingly positive

over our sample period, this suggests that limit orders have generally been on the wrong side of

the trades in the 1990s.

Panel B gives correlations among the three measures of the order imbalance, the concurrent daily

return on the S&P500 index, dollar volume, and the total number of transactions. All variables

are strongly positively correlated, with the exception of the correlations between the S&P500

return and NUMTRANS, and the S&P500 return and $VOL, which are virtually zero. This

points to the notion that the variable which relates trading activity to returns is order imbalance,

rather than aggregate trading volume.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 8

Panel C reports autocorrelations. Market order imbalances are persistent up to five daily lags but

the S&P500 return has no autocorrelation of any significance. Thus, the market appears to take

immediate account of the forecastable portion of the persistence in imbalance. 5 Changes in the

quoted spread are significantly negatively autocorrelated at lags of one and two days and are

positively autocorrelated at a lag of five days; the latter reveals a weekly seasonal in the quoted

spread.

Henceforth we will report regression results measuring order imbalance in transactions only. We

made this choice for the following reasons. First, the share measure of order imbalance is

influenced by stock splits and reverse splits, whereas the number of transactions is not directly

influenced by these events. Further, the dollar measure of order imbalance includes the price

level, and return and liquidity forecasts using a variable that includes the past price level may

lead to misleading conclusions. Thus, given the high correlations among different measures of

order imbalance, and based on the work of Jones et al. (1994) mentioned earlier, we perform our

regressions using OIBNUM; all three measures yield qualitatively similar results.

3. What Causes Order Imbalance?

On a given day, market-wide order imbalance could conceivably be caused by many factors.

Market returns and changes in macroeconomic variables such as interest rates immediately come

to mind. There is also some reason to expect weekly regularities in order imbalance, given the

regularities in daily returns (see, e.g., Gibbons and Hess, 1981) and the weekly regularities in

market liquidity documented by Chordia, Roll, and Subrahmanyam (2001). Finally, if temporary

5
An interesting feature of the OIBNUM series is that its first differences exhibit strong negative autocorrelation
which decays quickly.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 9
price pressures caused by imbalance are reversed by other traders, one would expect this to

manifest itself in the order imbalance series.

Based on the above arguments, in this section we ask whether order imbalance can be predicted

using past market returns after controlling for weekly regularities and past lagged values of order

imbalance. Thus, the daily order imbalance in number of transactions (OIBNUM) is regressed

on day-of-the-week dummies and variables designed to capture past up-market and down-market

moves, and on past values of order imbalance.

3.1 Regression Results

The time-series regression described above is reported in Table 2. The results show that, in

aggregate, investors act as contrarians. They buy after market declines and sell after market

advances. This behavior is particularly significant for market declines. For both market

advances and declines, the behavior persists for up to three days.

Although order imbalances are highly predictable, returns on the S&P500 index are virtually

uncorrelated. During our sample period, the first-order autocorrelation coefficient of the

S&P500 daily return is 0.005 (p-value=0.78), and higher-order coefficients are also close to zero.

Hence, order imbalances respond to past market moves in a manner that makes the S&P500

close to a random walk. The order imbalance pattern is consistent with price pressure caused by

inventory imbalances on a given day which is corrected by some investors taking the opposite

side of the market on the succeeding day. This phenomenon will be examined further in Section

5.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 10

As Table 2 also reveals, there appears to be a significant Wednesday regularity in order

imbalance. However, from Chordia et al. (2001), trading activity itself tends to be higher during

mid-week. To ascertain whether the above results are driven by trading activity per se, we scaled

the dependent variable OIBNUM by the total number of transactions (see Panel B of Table 2).

There remains strong evidence of a contrarian pattern in investor trading. The weekly seasonals

are now insignificant, suggesting that there is no significant seasonality in order imbalance after

controlling for the overall level of trading activity.

3.2 Summary of Results

The central results in this section are consistent with the inventory paradigm. In particular, the

paradigm suggests that after an event that causes a large inventory imbalance on one side of the

market, market makers set quotes to elicit trading on the other side of the market. Our evidence

that investors are contrarians on aggregate, i.e., they are net sellers after market rises, and vice

versa, indicates that they are successful in this endeavor and that temporary price pressures are,

in general countervailed effectively by financial market investors.

4. The Relation Between Liquidity and Order Imbalance

Theoretical paradigms of price formation predict that liquidity is influenced by inventory

concerns caused by an imbalance between buyer- and seller-initiated trades. For an individual

stock, a large order imbalance could be random or induced by either public or private

information. Regardless of the cause, market makers can be expected to respond by worsening

their offered terms of trade. At the market level, it seems unlikely that asymmetric information

is behind aggregate order imbalances, yet market maker inventories still experience periodic

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 11

strain. Such inventory problems could persist beyond a trading day and thus have extended

effects on liquidity. The next sub-sections provide empirical evidence about these possibilities.

4.1 Order Imbalance and Contemporaneous Changes in Liquidity

To measure liquidity, we first average each individual stock’s quoted spread over all daily

transactions, and then value-weight across stocks (as explained in Section 2 above). The daily

percentage change in the resulting market-average quoted spread is regressed on (1) a non-linear

function of the contemporaneous daily change in the absolute order imbalance between the

number of buyer- and seller-initiated trades, (2) the simultaneous daily percentage change in the

number of transactions, (3) concurrent return, and (4) concurrent market volatility (measured by

the absolute return on the S&P 500). Both the order imbalance and the number of transactions

are value-weight averaged over NYSE stocks in the S&P500 index.

The controls (2)-(4) are inserted to account for aggregate trading activity and market movements.

Order imbalance itself could be associated with greater trading activity as well as with large

market movements; however, our aim is untangle the incremental effect, if any, of order

imbalance on liquidity above and beyond its association with trading and price moves.

There is no theoretical guide to the functional form of the relation between liquidity and order

imbalance, so the extent of non-linearity was estimated empirically by employing a Box/Cox

transformation, F(x)=(xλ-1)/λ; (see Judge, et. al., 1985, ch. 20.) Since the absolute value of order

imbalance is taken prior to the non-linear transformation, the results (Table 3, second column)

indicate that higher spreads occur when orders are more unbalanced in either direction. The

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 12

effect turns out to be highly significant and non-linear, with a t-statistic of about 12 and a

curvature between cubic and quartic; the maximum likelihood estimate of λ being 3.19.

The change in the number of transactions has a separate and very significant positive impact on

spreads. This is a bit surprising in that order imbalance has already been taken into account.

One possible explanation is measurement error in the order imbalance variable thereby leaving

some explanatory scope for the number of trades. Another possibility is that changes in the sheer

volume of trading, without any imbalance in orders, makes it more difficult for market makers to

control inventory and induces them to respond by increasing quoted spreads. An alternative

explanation is that during periods of increased trading volume, the inside limit orders are picked

off, widening the difference between posted bid and ask quotes. In addition, market volatility as

measure by the absolute value of the contemporaneous market return, is positively associated

with changes in spreads, and, as in Chordia et al. (2001), market returns are negatively associated

with changes in spreads. As reported in the second column of Table 3, approximately 26% of

the average daily variation in quoted spreads is explained by these variables.

The overall implication is that contemporaneous changes in liquidity are strongly and non-

linearly associated with order imbalances , after controlling for both trading activity and for the

sign and magnitude of the market return. To some extent, the contemporaneous association

between the quoted spread and order imbalance could arise because of the inability of specialists

to adjust quotes on both sides of the market during periods of large imbalances. In particular, if

orders tend to occur on one side of the market during a period, then the specialist has to rapidly

adjust quotes or clear the limit order book on that side of the market. If the book on the other side

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 13

is not adjusted quickly enough, the spread will widen. Nevertheless, the widening of the spread

does reflect an increase in trading costs when order imbalances are high.

4.2 The Predictability of Liquidity

We use the same variables as in the previous subsection to predict the next day’s percentage

change in the market-wide quoted spread. The ensuing results are reported in the third column

of Table 3. While order imbalance appears to have no forecasting ability, there is evidence that

both the number of trades and the market return can predict future changes in liquidity.

Controlling for the market return, the predictive power of volatility is only marginal. To further

disentangle the role of market moves, instead of the return and its absolute value, separate

variables for up and down market moves are used in the regression reported in the last column of

Table 3. We find that liquidity persistently follows previous market moves. A down market

predicts low liquidity (higher spreads) the next day. An up-market also predicts higher liquidity

the next day though the magnitude of the effect is much smaller than for a previous down

market.

Table 3 shows also that an increase in transactions is associated with a spread increase on the

following day (as well as on the same day). The R2 of this forecasting regression is about 13%

which, not surprisingly, is lower than that for the contemporaneous spread regression reported in

the second column of the Table. These results are consistent with inventory models of the spread

(e.g., Stoll, 1978a). In such models, imbalances cause a shift in quotes but do not affect

liquidity. However, market movements do affect liquidity, and our results show that it is down

markets where the effects of index movements exert the strongest effects on liquidity. A

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 14

plausible explanation for this finding is that inventory financing constraints are more binding in

falling markets where specialist inventory levels might become very high.

4.3 Summary of Results

The data reveal a very strong contemporaneous association between changes in the absolute level

of market-wide order imbalance and market-wide liquidity. There is also strong evidence that

changes in liquidity can be predicted using market returns. In particular, liquidity falls following

market declines. For academics, these results are consistent with the notion that inventory risk

increases during periods of large price fluctuations. From a practical standpoint, they have

important implications for the design of trading strategies. For example, it would seem unwise

to trade on days immediately following a down-market if waiting costs are not very high.

Similarly, portfolio managers would do well to avoid trading on days when the preponderance of

trades is on one side of the market.

5. Daily Market Returns, Order Imbalance, and Liquidity

Inventory concerns could influence risk premia and thus alter required returns (Stoll, 1978a, and

Spiegel and Subrahmanyam, 1995). Empirical studies of block trading dating back to Kraus and

Stoll (1972) find that large trades induce price pressures. In either case, there is reason to expect

that aggregate market order imbalances can exert pressure on market returns; so this section

provides information on the phenomenon by estimating the directional impact of order

imbalances on contemporaneous and future market returns.

In such an empirical investigation one would ideally use a market index unaffected by non-

synchronous trading and the concomitant nuisance of spurious serial dependence. The S&P500
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 15
is actually quite appropriate. As mentioned in Section 3, during our January 1988 through

December 1998 sample period, it displayed virtually no unconditional serial dependence (see

Table 1, Panel C). Returns on the S&P500 appear to be unpredictable by their own past values.

5.1 Returns, Order Imbalance, and Liquidity

To examine the relation between S&P500 returns and order imbalances, a signed measure of

order imbalance is desirable (in contrast to the absolute value used in the liquidity regression of

Table 3). So, order imbalance is split into positive and negative parts and included as separate

regressors. This allows for a differential impact of excess buy and sell orders.

The second column of Table 4, Panel A shows that contemporaneous order imbalance (as

measured by OIBNUM) exerts an extremely significant impact on market returns in the expected

direction; the positive coefficients imply that excess buy (sell) orders drive up (down) prices.

Interestingly, lagged order imbalance exert a significant negative effect on the current day's

return after controlling for the contemporaneous order imbalance. This is consistent with

inventory stabilization, wherein the previous day's imbalance is reversed and hence exerts a

negative effect on the contemporaneous return. Given the well-known noise in daily returns, the

explanatory power is good: an adjusted R-square of 28%. A significant portion of daily stock

market movement can be explained by the buying and selling activity of the general public.

These results reveal that microstructure effects are not restricted to the level of the individual

stocks; they influence the price process at the aggregate market level.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 16

The third column of Table 4, Panel A adds lagged negative and positive market returns.

Surprisingly, even though the S&P500 has virtually zero unconditional serial correlation, these

lagged returns are highly significant. Controlling for order imbalances, both positive returns and

negative returns exhibit continuation. The explanatory power is impressive: 33%. However, it

seems unlikely that these results reveal a profit opportunity because only specialists know order

imbalances in real time for individual stocks and no specialist knows it for all stocks in

aggregate.

To check whether predictability is present without contemporaneous order imbalance

knowledge, we estimated the regression reported in the fourth column of Table 4. Lagged order

imbalances become insignificant when not accompanied by their contemporaneous counterparts.

The lagged market returns also fall in magnitude, but remain significant. However, given the

difficulty of procuring aggregate order imbalance data even with a one-day lag, there might be

some doubt that these results represent a profit opportunity based on publicly available

information.

At this point, the reader may wonder whether any of our results in this section are driven by the

relation between returns and unsigned trading volume. We did not include unsigned volume as

an explanatory variable in Table 4, Panel A because there is no strong a priori reason for volume

to be related to signed returns. However, inclusion of trading volume (dollar volume or number

of transactions) does not alter any of the results of Panel A. The regressions including unsigned

volume are available from the authors upon request.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 17

The fifth column of Table 4, Panel A reports a forecasting model for the next day’s market index

return using past returns alone, which would of course be publicly available information. As

might have been expected, the predictive power is minimal (adjusted R-square: 0.00772.)

However, the signed lagged market returns have surprisingly large significance levels. Despite

the virtual complete absence of ordinary serial dependence for the S&P500 index, the signed

lagged returns are both significant. A positive return tends to be followed by a continuation (as

revealed by the positive coefficient) while a negative return tends to be reversed. We thought

this surprising result, to our knowledge never before noticed, deserved mention and further

discussion.

Given the results of Atkins and Dyl (1990) and Cox and Peterson (1994), who find reversals in

individual stocks following large stock price declines, there is ample reason to believe that

market-wide reversals genuinely follow market crashes and that the phenomenon is not an

artifact of the data. To investigate further, we calculated the correlation corr(Rt , Rt-1 |Rt-1 <-1%)

and corr(Rt , Rt-1 |Rt-1 <-0.1%). The values for the two correlations respectively are -0.304 (126

observations - p-value<0.0001) and -0.126 (1087 observations - p-value<0.0001). Thus, the

reversal effect is most pronounced after larger market declines. We also calculated the

corresponding correlations for up-markets, corr(Rt , Rt-1 |Rt-1 >+1%) and corr(Rt , Rt-1 |Rt-1>+0.1%).

The values for the two correlations respectively are -0.033 (296 observations - p-value 0.57) and

+0.067 (1313 observations - p-value 0.02). Evidently, the continuation in up-markets is not

dependent on the size of the up-move.

Previous studies of block trading find that large block sales are followed by price reversals while

large buys are not (see Kraus and Stoll, 1972). To relate this empirical finding for individual

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 18

stocks to our market-wide data, we sorted all days by order imbalance and S&P500 return. We

then calculated the serial correlation for those days t (a) that fell into the top quintiles of both the

order imbalance and return sorts and (b) that fell into the bottom top quintiles of both the order

imbalance and return sorts. The serial correlation for days falling into category (b) was -0.290

(sample size=235) whereas that for those falling in category (a) was only -0.084 (sample

size=233). Hence, there is evidence of strong reversals following large negative return, large

negative imbalance days, but only weak reversals following large positive return, positive

imbalance days.

In Panel B of Table 4 reports a predictive regression using observations belonging to categories

(a) and (b). There is significant evidence that returns are predictable using past imbalances and

past returns following large negative order imbalance, large negative return days, but there is no

predictive power following high positive order imbalance, high positive return days. Two of the

four regressions reported in Panel B also control for aggregate trading volume, to ensure that the

predictability for high negative imbalance, large negative return days is not driven by the level of

unsigned trading volume. As can be seen, inclusion of dollar trading volume does not materially

alter the results, 6 underscoring the importance of imbalance in the predictive results.

5.2 Volatility, Volume, and Imbalance

Previous literature has focused extensively on the relation between volume and volatility (see,

e.g., Gallant, Rossi, and Tauchen, 1992). However, daily imbalances could provide information

about stock price movements in addition that provided by aggregate daily volume. For example,

if aggregate daily volume is driven by equal amounts of buying and selling activity, the impact

6
Trading volume measured in number of transactions does not change the qualitative results of Panel B either.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 19
of volume on price movements may be minimal, while if volume is driven by a large imbalance,

it could have a large impact. Note that the exercise of disentangling the role of volume vis a vis

imbalance in explaining stock price fluctuations is best done using volatility as the dependent

variable. This is because, as we mentioned in the previous subsection, there is no a priori reason

to believe that unsigned volume would have an effect on signed returns. We therefore explore

the role of unsigned order imbalances in explaining return volatility over and above the influence

of trading volume.

Table 5 provides some information about this issue. The first regression, reported in the second

column, regresses the absolute value of the S&P500 contemporaneous return on dollar volume,

the positive and negative parts of order imbalance, the average quoted spread, and the lagged

absolute market return. The quoted spread is included to control for any liquidity effect on

volatility while the lagged absolute return is included to account for the well-documented

persistence in volatility.

Sure enough, order imbalance is significant. The effect is asymmetric; excess sell orders have an

impact four times that of excess buy orders; this result is consistent with that in Table 4, Panel B,

wherein large sell orders have a greater price impact. Both volume and quoted spreads are also

significant. Thus, considerable improvement in explanatory power for contemporaneous daily

volatility can be obtained by accounting for the joint and several influences of all these variables.

Notice that the lagged absolute market return has a negative coefficient. Its persistence is,

therefore, fully offset by the other variables.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 20

In the third column of Table 5, the same variables are used to predict volatility on the following

day. Here, order imbalance disappears as a significant explanatory factor while dollar volume

and the lagged quoted spread retain their significance. The lagged volatility proxy |Rt | now has a

significant positive impact on |Rt+1 |, thereby verifying the usual finding. Evidently, the

persistence in volatility is induced partly by persistent levels of volume and liquidity. In

contrast, but perhaps not surprisingly, order imbalance has only a fleeting influence on volatility.

So the effect of imbalance on future volatility is subsumed by the influences of lagged liquidity

and past volatility.

5.4 Summary of Results

There is a strong contemporaneous association between stock returns and order imbalance.

There is evidence that market prices tend to reverse following declines and continue following

previous up-moves. Reversal effects are particularly pronounced after large down-market, large

negative imbalance days. Our results are consistent with the inventory paradigm, which suggests

that imbalances cause price pressures, and with the block trading literature for individual stocks,

which indicates that price pressures caused by large sell orders are greater than those for buy

orders. Order imbalance also has an impact on contemporaneous volatility above and beyond the

well-known influence of trading volume. Our results underscore the point that price pressures

caused by imbalances are not an artifact of price formation at the individual stock level; they also

manifest themselves at the aggregate market level. This finding has direct implications for

agents wishing to trade the aggregate market portfolio.

6. Conclusion

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 21

The relations between trading activity and liquidity and between trading activity and market

returns have been explored extensively. Trading activity has usually been measured by volume,

but the inventory paradigm, (developed, for example, in Stoll, 1978a, and Spiegel and

Subrahmanyam, 1995) suggests that the imbalance between buyer- and seller-initiated orders

could be a powerful determinant of liquidity and price movements beyond trading volume per se.

This turns out to be empirically upheld by a daily index of aggregate market order imbalance for

NYSE stocks.

Our analysis of the determinants and properties of market-wide order imbalances, and of the

relation between order imbalances, liquidity, and daily stock market returns is generally

consistent with the inventory paradigm and yields the following empirical stylized facts:

• Order imbalances are strongly related to past market returns. There is evidence of aggregate

contrarian behavior; signed order imbalances are high following market crashes and low

following market increases. Since returns on the S&P500 are virtually uncorrelated, this is

evidence that price pressures and inventory imbalances are countervailed efficiently by the

market participants.

• Liquidity is predictable from market returns, but not from past imbalances. In particular,

down market days tend to be followed by days of decreased liquidity. These findings are

consistent with inventory models of liquidity such as Stoll (1978a), where imbalance affects

the placement of quotes but not the size of the bid-ask spread, and with the notion that

spreads depend on the costs of holding inventory, which arise from risk and financing

constraints. Our results indicate that such costs are particularly high in down markets.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 22

• There is some evidence that reversals tend to follow negative market returns while positive

returns tend to be continued. Returns following large negative order imbalance, large

negative return days are partially predictable using order imbalance and return, but the same

is not true for large positive imbalance, large positive return days. This result is consistent

with the block trading literature for individual stocks dating back to Kraus and Stoll (1972),

wherein large block sells are followed by reversals but large block buys are not. Our results

indicate that price pressure effects of large trades are not restricted to individual stocks but

also influence returns at the aggregate market level; this has implications for agents wishing

to trade large dollar amounts of a diversified market portfolio.

• Order imbalances are strongly related to contemporaneous absolute returns after controlling

for market volume and market liquidity. This underscores the importance of accounting for

order imbalance, in addition to volume, as a determinant of return volatility.

To our knowledge, this is the first study to analyze daily order imbalances for a comprehensive

sample of stocks over a long sample period. Our results generally indicate that imbalances affect

liquidity and returns not just at the individual stock level but at the aggregate market level as

well. Since private information is not likely to be an issue at the aggregate market level, the

results generally support the notion that the inventory paradigm, wherein market makers

accommodate uninformed imbalances from outside agents, plays an important role in price

formation in the stock market.

Data for order imbalance open arenas of research beyond those in this paper. For example,

analyzing order imbalances over longer horizons could shed light on growth/value effects in

returns and how they relate to investor trading patterns. In addition, order imbalances around

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 23

major macroeconomic announcements could help shed additional light on the information

paradigm by ascertaining whether agents are able to predict the sign of the impending

announcement. These and other possible topics are left for future research.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 24

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Order Imbalance, Liquidity, and Market Returns, April 12, 2001 27

 Table 1
Market-wide Order Imbalance – Summary statistics and correlations
Descriptive statistics are given for average daily order imbalance measures from NYSE stocks belonging
to the S&P 500 over 1988-1998 inclusive, 2,779 observations. Trades are signed using the Lee and
Ready (1991) algorithm. OIBNUM, OIBSH, and OIBDOL measure the value-weighted7 order
imbalance in number of transactions, shares, and dollars, respectively. $VOL, NUMTRANS, and QSPR
are the value-weighted averages of dollar volume (in millions of dollars), number of transactions, and the
average daily quoted spread, respectively. The variables DQSPR and DOIBNUM denote the daily
percentages and the daily first differences in QSPR and OIBNUM, respectively. S&P500 is the daily
return on the Standard & Poor’s 500 Index.

Panel A: Summary statistics

Standard
Mean Median
Deviation
OIBNUM 34.89 27.22 57.48
OIBSH/1 x 103 59.71 45.40 97.12
OIBDOL/1 x 106 4.167 2.830 6.498
|OIBNUM| 90.33 78.61 52.71
|OIBSH|/1 x 103 168.0 147.0 86.04
|OIBDOL|/1 x 109 9.628 7.560 6.165
QSPR 0.182 0.187 0.030
NUMTRANS 658.0 534 399.0
$VOL 58.37 40.17 42.17
DQSPR(%) 2.66 1.98 2.63

Panel B: Correlations
OIBNUM OIBSH OIBDOL NUMTRANS $VOL
OIBSH 0.523
OIBDOL 0.531 0.961
NUMTRANS 0.533 0.468 0.563
$VOL 0.476 0.509 0.609 0.971
S&P500 0.408 0.599 0.528 0.012 0.024

Panel C. Autocorrelations 8
Lag Quoted
OIBNUM OIBSH OIBDOL S&P500 DOIBNUM
(Days) Spread
1 0.539 0.376 0.465 0.005 -0.321 -0.420
2 0.470 0.322 0.421 -0.023 -0.096 -0.074
3 0.469 0.297 0.400 -0.032 -0.022 -0.037
4 0.434 0.290 0.399 -0.018 -0.022 -0.016
5 0.414 0.271 0.384 -0.023 -0.023 0.034

7
The value weights are proportional to market capitalization at the end of the previous calendar year.
8
Values in bold face are significantly non-zero with an asymptotic p-value less than 0.00001.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 28
 Table 2

What causes Market-wide Order Imbalance?

The dependent variable is the daily order imbalance measured in number of transactions
(OIBNUMt ) on trading day t. It is regressed on day-of-the-week dummies and past positive and
negative parts of S&P500 returns; Rt denotes the S&P500 index return on day t. The
Cochrane/Orcutt procedure was applied to correct for first-order serial dependence in the
residuals. In Panel A, the dependent variable is the value-weighted order imbalance for NYSE-
listed stocks in the S&P 500 index. In Panel B the dependent variable is
OIBNUMt /NUMTRANSt , where NUMTRANS is total number of transactions (again value-
weighted for NYSE stocks in the S&P500). 1988-98 inclusive, 2779 observations. T-statistics
are in parentheses.

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 29

 Panel A: Dependent variable is the value-weighted order imbalance for NYSE
stocks in the S&P 500
Coefficient
Explanatory variable
(t-statistic)
-0.992
Intercept
(-0.43)
-1.80
Monday
(-0.70)
6.60
Tuesday
(2.64)
5.85
Wednesday
(2.33)
0.020
Thursday
(0.01)
-30.06
Min(0, Rt-1)
(-17.70)
-2.80
Min(0, Rt-2)
(-1.59)
-6.25
Min(0, Rt-3)
(-3.52)
-1.92
Min(0, Rt-4)
(-1.08)
-1.16
Min(0, Rt-5)
(-0.66)
-8.93
Max(0, Rt-1)
(-4.94)
0.465
Max(0, Rt-2)
(0.26)
-6.75
Max(0, Rt-3)
(-3.71)
-2.47
Max(0, Rt-4)
(-1.36)
-1.57
Max(0, Rt-5)
(-0.88)
0.464
OIBNUMt-1
(20.18)
0.047
OIBNUMt-2
(1.83)
0.178
OIBNUMt-3
(7.04)
0.067
OIBNUMt-4
(2.62)
0.064
OIBNUMt-5
(2.85)
Durbin Watson 2.01
Cochrane-Orcutt autocorrelation -0.011
Adjusted R2 0.477

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 30

 Panel B: Dependent variable is OIBNUM/NUMTRANS
Coefficient
Explanatory variable
(t-statistic)
0.544
Intercept
(1.68)
-0.372
Monday
(-1.06)
0.161
Tuesday
(0.47)
0.605
Wednesday
(1.76)
-0.345
Thursday
(-1.00)
-2.319
Min(0, Rt-1)
(-9.58)
-1.225
Min(0, Rt-2)
(-5.05)
-0.535
Min(0, Rt-3)
(-2.17)
-0.546
Min(0, Rt-4)
(-2.22)
0.828
Min(0, Rt-5)
(-3.43)
-1.750
Max(0, Rt-1)
(-7.04)
-0.369
Max(0, Rt-2)
(-1.46)
-0.877
Max(0, Rt-3)
(-3.48)
-0.449
Max(0, Rt-4)
(-1.79)
-0.530
Max(0, Rt-5)
(-2.14)
0.387
OIBNUMt-1
(15.99)
0.121
OIBNUMt-2
(4.67)
0.120
OIBNUMt-3
(4.63)
0.093
OIBNUMt-4
(3.59)
0.120
OIBNUMt-5
(4.96)
Durbin Watson 2.01
Cochrane-Orcutt autocorrelation -0.014
Adjusted R2 0.408

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 31

 Table 3
Changes in Market Liquidity, Contemporaneous Changes in Order Imbalance and the
Number of Transactions, and Market Up and Down Moves
The dependent variables are the contemporaneous and next-day’s daily percentage change in the
value-weighted 9 quoted spread for NYSE-listed stocks in the S&P500. Explanatory variables
include the daily first difference in a Box/Cox transformation of the absolute value of the value-
weighted order imbalance for NYSE stocks in the S&P500 measured in number of shares
(OIBNUM), the daily percentage change in the number of transactions for NYSE stocks in the
S&P 500, the S&P 500 return if it is positive, and zero otherwise (S&P500+), and the S&P 500
return if it is negative, and zero otherwise (S&P500-). The Cochrane/Orcutt procedure was
applied to correct for first-order serial dependence in the residuals. The Box/Cox
transformation’s λ is estimated by maximizing the explanatory power of the contemporaneous
regression using the original variables and the Cochrane/Orcutt coefficient estimates. 2778
observations, 1988-98 inclusive. T-statistics are in parentheses

Percentage change Percentage Percentage

in value-weighted change in change in
quoted spread value-weighted value-weighted
(contemporaneous) quoted spread quoted spread
(next day) (next day)
Coefficient Coefficient Coefficient
Explanatory variable
(t-statistic) (t-statistic) (t-statistic)
75.63 -10.77 -10.77
(|OIBNUMt |λ-|OIBNUMt-1 |λ)/λ
(11.83) (-1.59) (-1.59)
0.036 0.011 0.011
% Change in Number of Trades
(10.80) (3.11) (3.11)
-0.931 -0.425
S&P500
(-14.14) (-5.50)
0.654 0.177
|S&P500|
(7.06) (1.64)
-0.248
S&P500+
(-1.87)
-0.602
S&P500-
(-4.52)
Lagged (one-day)dependent -0.264 -0.264
variable (-11.04) (-11.04)
-0.484 -0.054 -0.054
Intercept
(-4.97) (0.54) (-0.54)
Adjusted R2 0.261 0.129 0.129
λ 3.19 3.19 3.19
Durbin-Watson 2.16 2.08 2.08
Cochrane/Orcutt autocorrelation -0.353 -0.182 -0.182

9
The value weights are proportional to market capitalization at the end of the previous calendar year.
Order Imbalance, Liquidity, and Market Returns, April 12, 2001 32
 Table 4

Returns on the S&P500 Stock Market Index,

Contemporaneous and Lagged Order Imbalances
and Lagged Returns

The dependent variable is the daily return on the S&P500 index, denoted Rt . Explanatory
variables include contemporaneous and lagged positive and negative daily order imbalances
measured in number of trades and lagged positive and negative index returns. Order imbalances
are value-weighted averages for NYSE stocks in the S&P500. For Panel B, days are sorted
separately by OIBNUM and by the S&P500 return. Then a predictive regression is fit using
observations that are common to the top 20% of days with high imbalance as well as the top 20%
of days with high returns. Another predictive regression is run for high sell order imbalance,
large negative return days (i.e., days that are common to the bottom 20% of both variables). The
results for these two regressions are reported respectively in the second and third columns of
Panel B. Data cover 1988-98 inclusive. T-statistics are in parentheses.

Panel A: Dependent variable: Rt

Excess Buy Orders, 6.83 8.63
Max[0,OIBNUMt ] (19.88) (24.03)
Excess Sell Orders, 22.44 23.59
-Min[0,OIBNUMt ] (19.85) (21.57)
Excess Buy Orders, -4.56 -7.01 -0.218
Max[0,OIBNUMt-1 ] (-13.13) (-18.61) (-0.60)
Excess Sell Orders, -5.83 -10.42 -2.69
-Min[0,OIBNUMt-1 ] (-5.12) (-8.72) (-1.90)
Lagged Positive 0.314 0.148 0.135
Return, max[0,Rt-1 ] (10.59) (4.16) (4.12)
Lagged Negative 0.235 -0.094 -0.122
Return, min[0,Rt-1 ] (7.61) (-2.67) (-3.77)
0.058 0.024 -0.021 -0.0187
Intercept
(2.63) (1.06) (-0.82) (-0.807)
Adjusted R2 0.281 0.332 0.00882 0.00772
Number of Observations 2778 2778 2778 2778

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 33

 Panel B: Dependent variable: Rt+1
Days with OIBNUMt in
Days with OIBNUMt in top
bottom quintile and Rt in
quintile and Rt in top quintile
bottom quintile
Lagged order imbalance -0.408 -0.914 -7.59 -8.42
(OIBNUMt ) (-0.53) (-1.08) (-2.36) (-2.59)
-0.086 -0.103 -0.233 -0.267
Lagged return (Rt ) (-0.90) (-1.07) (-2.88) (-3.19)
0.182 -0.263
Lagged volume ($VOLt )
(1.36) (-1.52)
0.360 0.273 -0.390 -0.329
Intercept
(2.56) (1.77) (-3.25) (-2.62)
Adjusted R2 -0.001 0.003 0.098 0.103
Number of Observations 233 233 235 235

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 34

 Table 5

Absolute Returns on the S&P500 Stock Market Index,

Order Imbalance, Volume and Liquidity

The dependent variable is the absolute value of the daily return on the S&P500 index, denoted
|Rt |. Explanatory variables include contemporaneous and lagged positive and negative daily
order imbalances measured in number of trades, dollar volume, and quoted spreads. Order
imbalances, volume, and spreads are value-weighted averages for NYSE stocks in the S&P500.
Data cover 1988-98 inclusive. T-statistics are in parentheses.

Dependent Variable
|Rt | |Rt+1 |
Coefficient
Explanatory Variable
(t-statistic)
Excess Buy Orders, 2.40 -0.474
Max[0,OIBNUMt ] (9.67) (-1.71)
Excess Sell Orders, 10.7 0.0542
Min[0,OIBNUMt ] (13.1) (0.0577)
Dollar Volume 0.825 0.552
($VOLt /100) (19.0) (11.4)
10.1 4.95
Quoted Spreadt
(18.1) (7.98)
-0.0556 0.0481
One-day lagged |R|
(-3.07) (2.28)
-1.82 -0.620
Intercept
(-15.5) (-4.74)
Adjusted R-Square 0.247 0.0664
Number of Observations 2778 2778

Order Imbalance, Liquidity, and Market Returns, April 12, 2001 35