Mechanical vs. informational components of price impact
Santa Fe Institute, 1399 Hyde Park Road, Santa Fe, NM, 87501, USA
2 School of IT, Faculty of Science, The University of Sydney, Sydney, Australia
Revised: 19 September 2006
Published online: 25 October 2006
We study the problem of what causes prices to change. It is well known that trading impacts prices — orders to buy drive the price up, and orders to sell drive it down. We introduce a means of decomposing the total impact of trading into two components, defining the mechanical impact of a trading order as the change in future prices in the absence of any future changes in decision making, and the informational impact as the remainder of the total impact once mechanical impact is removed. This decomposition is performed using order book data from the London Stock Exchange. The average mechanical impact of a market order decays to zero as a function of time, at an asymptotic rate that is consistent with a power law with an exponent of roughly 1.7. In contrast the average informational impact builds to approach a constant value. Initially the impact is entirely mechanical, and is about half as big as the asymptotic informational impact. The size of the informational impact is positively correlated to mechanical impact. For cases where the mechanical impact is zero for all times, we find that the informational impact is negative, i.e. buy market orders that have no mechanical impact at all generate strong negative price responses.
PACS: 89.65.Gh – Economics; econophysics, financial markets, business and management
© EDP Sciences, Società Italiana di Fisica, Springer-Verlag, 2006