Track 01Module 2 of 58 sources
Price impact and informed flow
Understand why size moves price, why the cost of size grows slower than size, and how market makers detect dangerous flow.
Key ideas
- Kyle's lambda: market makers cannot see who is informed, so they move price in proportion to net order flow. That slope is price impact.
- Over short horizons, price change is close to linear in order flow imbalance at the best quotes. This is the empirical basis for tape reading.
- For large parent orders, impact grows roughly with the square root of size. Doubling size does not double cost, but it never comes free.
- Flow is toxic when it predicts the next price move. Market makers respond by widening spreads or pulling quotes, which is why liquidity vanishes exactly when you need it.
Start hereWatch or read these first. They carry the core idea.
Paper
The Price Impact of Order Book Events
Cont, Kukanov, Stoikov · 2013 · Journal of Financial Econometrics · doi:10.1093/jjfinec/nbt003 · free copy
Shows that short-term price changes are driven by order flow imbalance at the best bid and ask. Read the abstract and section 2 first.
CoreThe standard references. Work through them once the idea is clear.
Paper
Continuous Auctions and Insider Trading
Kyle · 1985 · Econometrica · doi:10.2307/1913210
The founding model. An informed trader hides in noise and the market maker sets price from net order flow.
Paper
How Markets Slowly Digest Changes in Supply and Demand
Bouchaud, Farmer, Lillo · 2008 · doi:10.2139/ssrn.1266681 · free copy
Why order flow is highly persistent yet prices stay close to unpredictable. Introduces the square-root impact law.
Where market making meets market microstructure
Video · Sasha Stoikov · 1:19:42
How a market maker thinks about inventory, adverse selection and fair value, from the researcher who formalised the micro-price.
Paper
Flow Toxicity and Liquidity in a High-frequency World
Easley, López de Prado, O'Hara · 2012 · Review of Financial Studies · doi:10.1093/rfs/hhs053
VPIN, a measure of flow toxicity in volume time. Read it with some scepticism. The result is debated.
Go deeperResearch, primary sources and data for when you want the detail.
Paper
The micro-price: a high-frequency estimator of future prices
Stoikov · 2018 · Quantitative Finance · doi:10.1080/14697688.2018.1489139
A better fair-value estimate than the mid price, built from book imbalance.
Book
Trades, Quotes and Prices
Jean-Philippe Bouchaud, Julius Bonart, Jonathan Donier
The book-length treatment, with data. Best single source on impact.
Stochastic Market Microstructure Models of Limit Order Books
Video · INFORMS · 1:28:22
A research talk on queueing models of the book. For the mathematically inclined.
Practice
For one stock you trade, compare the day's range on days with twice the average volume against normal days. That ratio is your first rough measure of impact.
See it live
Where this leads
01.4 · Order Flow and MicrostructureExecution: getting in and out without overpayingChoose order types on purpose, measure your own slippage, and understand how institutions slice large orders.02.3 · Options and Options FlowDealer positioning: gamma, vanna, charm and pinningExplain how dealer hedging can dampen or amplify moves, and read a gamma exposure estimate with the right amount of doubt.