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Estimating the Probability of Informed Trading - Does Trade Misclassification Matter?

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  • Joachim Grammig
  • Erik Theissen

Abstract

Easley / Kiefer / O'Hara / Paperman (1996) (EKOP) have proposed an empirical methodology that allows to estimate the probability of informed trading and that has subsequently been used to address a wide range of issues in market microstructure. The data needed for estimation is the number of buyer- and seller-initiated trades. This information often has to be inferred by applying trade classification algorithms like the one proposed by Lee / Ready (1991). These algorithms are known to be inaccurate. In this paper we perform extensive simulations to show that inaccurate trade classification leads to biased estimation of the probability of informed trading when applying the EKOP methodology. The estimate is biased downward and the magnitude of the bias is related to the trading intensity of the stock in question. Scrutinizing prior empirical studies using the EKOP methodology, we conclude that the bias may severely affect the results of empirical microstructure studies.

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Bibliographic Info

Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse37_2002.

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Length: 24
Date of creation: Dec 2002
Date of revision:
Handle: RePEc:bon:bonedp:bgse37_2002

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Keywords: Informed trading; market microstructure; trade classification;

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References

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  1. Theissen, Erik, 2001. "A test of the accuracy of the Lee/Ready trade classification algorithm," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 11(2), pages 147-165, June.
  2. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1996. " Cream-Skimming or Profit-Sharing? The Curious Role of Purchased Order Flow," Journal of Finance, American Finance Association, vol. 51(3), pages 811-33, July.
  3. David Easley & Soeren Hvidkjaer & Maureen O'Hara, 2002. "Is Information Risk a Determinant of Asset Returns?," Journal of Finance, American Finance Association, vol. 57(5), pages 2185-2221, October.
  4. Lee, Charles M. C. & Radhakrishna, Balkrishna, 2000. "Inferring investor behavior: Evidence from TORQ data," Journal of Financial Markets, Elsevier, vol. 3(2), pages 83-111, May.
  5. Ellis, Katrina & Michaely, Roni & O'Hara, Maureen, 2000. "The Accuracy of Trade Classification Rules: Evidence from Nasdaq," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(04), pages 529-551, December.
  6. Easley, David & O'Hara, Maureen & Saar, Gideon, 2001. "How Stock Splits Affect Trading: A Microstructure Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 36(01), pages 25-51, March.
  7. Easley, David & O'Hara, Maureen & Paperman, Joseph, 1998. "Financial analysts and information-based trade," Journal of Financial Markets, Elsevier, vol. 1(2), pages 175-201, August.
  8. Finucane, Thomas J., 2000. "A Direct Test of Methods for Inferring Trade Direction from Intra-Day Data," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(04), pages 553-576, December.
  9. Grammig, J. & Schiereck, D. & Theissen, E., 2001. "Knowing Me, Knowing You: Trader Anonymity and Informed Trading in Parallel Markets," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 35288, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).
  10. Easley, David, et al, 1996. " Liquidity, Information, and Infrequently Traded Stocks," Journal of Finance, American Finance Association, vol. 51(4), pages 1405-36, September.
  11. Lee, Charles M C & Ready, Mark J, 1991. " Inferring Trade Direction from Intraday Data," Journal of Finance, American Finance Association, vol. 46(2), pages 733-46, June.
  12. Odders-White, Elizabeth R., 2000. "On the occurrence and consequences of inaccurate trade classification," Journal of Financial Markets, Elsevier, vol. 3(3), pages 259-286, August.
  13. Easley, David & O'Hara, Maureen, 1992. " Time and the Process of Security Price Adjustment," Journal of Finance, American Finance Association, vol. 47(2), pages 576-605, June.
  14. Easley, David & O'Hara, Maureen, 1987. "Price, trade size, and information in securities markets," Journal of Financial Economics, Elsevier, vol. 19(1), pages 69-90, September.
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Citations

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Cited by:
  1. Ali, Ashiq & Klasa, Sandy & Zhen Li, Oliver, 2008. "Institutional stakeholdings and better-informed traders at earnings announcements," Journal of Accounting and Economics, Elsevier, vol. 46(1), pages 47-61, September.
  2. Torben G. Andersen & Oleg Bondarenko, 2013. "Assessing Measures of Order Flow Toxicity via Perfect Trade Classification," CREATES Research Papers 2013-43, School of Economics and Management, University of Aarhus.
  3. Yan, Yuxing & Zhang, Shaojun, 2012. "An improved estimation method and empirical properties of the probability of informed trading," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 454-467.
  4. Asquith, Paul & Oman, Rebecca & Safaya, Christopher, 2010. "Short sales and trade classification algorithms," Journal of Financial Markets, Elsevier, vol. 13(1), pages 157-173, February.
  5. Hanousek, Jan & Podpiera, Richard, 2004. "Czech experience with market maker trading system," Economic Systems, Elsevier, vol. 28(2), pages 177-191, June.
  6. Visaltanachoti, Nuttawat & Charoenwong, Charlie & Ding, David K., 2011. "Information asymmetry in warrants and their underlying stocks on the stock exchange of Thailand," Journal of Empirical Finance, Elsevier, vol. 18(3), pages 474-487, June.
  7. Jan Hanousek & František Kopøiva, 2011. "Detecting Information-Driven Trading in a Dealers Market," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 61(3), pages 204-229, July.
  8. Grammig, Joachim & Theissen, Erik & Wuensche, Oliver, 2007. "Time and price impact of a trade: A structural approach," CFR Working Papers 07-12, University of Cologne, Centre for Financial Research (CFR).
  9. Yan, Yuxing & Zhang, Shaojun, 2014. "Quality of PIN estimates and the PIN-return relationship," Journal of Banking & Finance, Elsevier, vol. 43(C), pages 137-149.
  10. Hwang, Lee-Seok & Lee, Woo-Jong & Lim, Seung-Yeon & Park, Kyung-Ho, 2013. "Does information risk affect the implied cost of equity capital? An analysis of PIN and adjusted PIN," Journal of Accounting and Economics, Elsevier, vol. 55(2), pages 148-167.
  11. Jackson, David, 2013. "Estimating PIN for firms with high levels of trading," Journal of Empirical Finance, Elsevier, vol. 24(C), pages 116-120.
  12. Brownlees, C.T. & Gallo, G.M., 2006. "Financial econometric analysis at ultra-high frequency: Data handling concerns," Computational Statistics & Data Analysis, Elsevier, vol. 51(4), pages 2232-2245, December.
  13. Byun, Hae-Young & Hwang, Lee-Seok & Lee, Woo-Jong, 2011. "How does ownership concentration exacerbate information asymmetry among equity investors?," Pacific-Basin Finance Journal, Elsevier, vol. 19(5), pages 511-534, November.
  14. William Lin, Hsiou-Wei & Ke, Wen-Chyan, 2011. "A computing bias in estimating the probability of informed trading," Journal of Financial Markets, Elsevier, vol. 14(4), pages 625-640, November.
  15. Igor Filatotchev & Xiaoxiang Zhang & Jenifer Piesse, 2011. "Multiple agency perspective, family control, and private information abuse in an emerging economy," Asia Pacific Journal of Management, Springer, vol. 28(1), pages 69-93, March.
  16. Paul Asquith & Rebecca Oman & Christopher Safaya, 2008. "Short Sales and Trade Classification Algorithms," NBER Working Papers 14158, National Bureau of Economic Research, Inc.
  17. Kaun Y. Lee & Kee H. Chung, 2009. "Information-Based Trading and Price Improvement," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(5-6), pages 754-773.
  18. Frantisek Kopriva, 2008. "Source of Information-Driven Trading on the Prague Stock Exchange," CERGE-EI Working Papers wp365, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  19. Gordon, Narelle & Watts, Edward & Wu, Qiongbing, 2014. "Information attributes, information asymmetry and industry sector returns," Pacific-Basin Finance Journal, Elsevier, vol. 26(C), pages 156-175.
  20. Akay, Ozgur (Ozzy) & Cyree, Ken B. & Griffiths, Mark D. & Winters, Drew B., 2012. "What does PIN identify? Evidence from the T-bill market," Journal of Financial Markets, Elsevier, vol. 15(1), pages 29-46.

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