Market Lens #3
In this Market Lens mini-series, BMLL takes a deeper look at Market Impact. Here we explore how a better understanding of that impact can lead to better execution outcomes.
We start by examining high frequency market impact and how we can utilise it to better understand the market microstructure around latency arbitrage and algorithmic market making.
The Question: Can understanding correlated Market Impact improve execution?
The Answer: When securities exhibit correlated market impacts, the decisions a trader makes in regards to passive order placement vs. aggressively crossing the spread are heightened.
Here we define uncorrelated market impact as price movement as a result of order book interaction, i.e. a buy/sell order is placed in the market, and mid-price rises/falls as new information feeds through the displayed market. On the other hand, correlated market impact is defined as price movements when new events on one security trigger a change in the mid-price for another security.
Exhibit 1: S&P E-mini future leads the SPY ETF by 4ms
Securities that are based on similar underlying assets (e.g. S&P E-minis futures and SPY ETF) exhibit strongly correlated market impact. Irrespective of the cause of the price movement, traders looking to exploit market moves between these correlated securities need to act fast. A well known example is between CME futures and the corresponding NYSE indices, where crossing the Appalachian Mountains can take as little as 4 milliseconds for trading signals sent from Chicago to reach New York.
The Context: When correlated securities move, market makers want to pull out their quote that is now outdated, and offer a price that will very soon be on the wrong side of the mid price; whilst aggressive traders want to lift that outdated quote before it can be cancelled and take profit before the market makers realign their pricing. This is latency arbitrage trading at its core. This realignment can affect trading outcomes as prices "disappear" from trading systems that don't operate at that speed.
How Did We Do This? The BMLL Data Lab replays every order book message to get a true picture of market impact. For an event, BMLL computes metrics in each considered order book at the event time and offsets around it, considering each order book message processed between them. By scaling the compute up over days in May 2021 and averaging the impact, we are able to see the true impact of the considered events on the metric. Here, we considered how the 10,000 largest daily executions move the midpoint price. Note, these are the executions as reported in the public feed and correspond many-to-one to a large aggressive. We use the largest executions as smaller executions carry additional noise. This analysis utilised over 2 billion order book messages to determine these curves with maximum reliability. The BMLL Data Lab has multi-asset class nanosecond granularity in a scalable research environment as well as predefined market impact frameworks, giving quants the ultimate suite of tools to harness market impact and make more informed trading decisions.
The So What: It is important for traders and market participants to understand how market impact can affect trading, even though it happens at the millisecond scale. Price movements can have a material impact on smart order routing decisions, trading outcomes and best execution for clients. Whilst speed is critical, it is not the only tool in the arsenal. By leveraging the full depth order book, those risks can be analysed, quantified and ultimately mitigated resulting in better trading decisions.
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