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The simplicity of optimal trading in order book markets

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  • Paolo Pellizzari

    ()
    (Department of Economics, University Of Venice Cà Foscari)

  • Dan Ladley

    (Department of Economics Leicester University)

Abstract

A trader's execution strategy has a large effect on his profits. Identifying an optimal strategy, however, is often frustrated by the complexity of market microstructure's. We analyse an order book based continuous double auction market under two different models of trader's behaviour. In the first case actions only depend on a linear combination of the best bid and ask. In the second model traders adopt the Markov perfect equilibrium strategies of the trading game. Both models are analytically intractable and so optimal strategies are identified by the use of numerical techniques. Using the Markov model we show that, beyond the best quotes, additional information has little effect on either the behaviour of traders or the dynamics of the market. The remarkable similarity of the results obtained by the linear model indicates that the optimal strategy may be reasonably approximated by a linear function. We conclude that whilst the order book market and strategy space of traders are potentially very large and complex, optimal strategies may be relatively simple and based on a minimal information set.

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Bibliographic Info

Paper provided by Department of Economics, University of Venice "Ca' Foscari" in its series Working Papers with number 2014:05.

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Length: 24
Date of creation: 2014
Date of revision:
Handle: RePEc:ven:wpaper:2014:05

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Keywords: Continuous Double Auction; Order Book; Information; Optimal Trading;

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  1. Parlour, Christine A, 1998. "Price Dynamics in Limit Order Markets," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 11(4), pages 789-816.
  2. Chiarella, Carl & He, Xue-Zhong & Pellizzari, Paolo, 2012. "A Dynamic Analysis Of The Microstructure Of Moving Average Rules In A Double Auction Market," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 16(04), pages 556-575, September.
  3. Gode, Dhananjay K & Sunder, Shyam, 1993. "Allocative Efficiency of Markets with Zero-Intelligence Traders: Market as a Partial Substitute for Individual Rationality," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 101(1), pages 119-37, February.
  4. Chiarella, C. & Iori, G. & Perello, J., 2008. "The Impact of Heterogeneous Trading Rules on the Limit Order Book and Order Flows," Working Papers, Department of Economics, City University London 08/04, Department of Economics, City University London.
  5. Paolo Pellizzari, 2011. "Optimal trading in a limit order book using linear strategies," Working Papers, Department of Economics, University of Venice "Ca' Foscari" 2011_16, Department of Economics, University of Venice "Ca' Foscari", revised Sep 2011.
  6. Dan Ladley & Klaus Reiner Schenk-Hoppe, 2007. "Do Stylised Facts of Order Book Markets Need Strategic Behaviour?," Swiss Finance Institute Research Paper Series, Swiss Finance Institute 07-20, Swiss Finance Institute.
  7. Ioanid Rosu, 2009. "A Dynamic Model of the Limit Order Book," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(11), pages 4601-4641, November.
  8. Ronald L. Goettler & Christine A. Parlour & Uday Rajan, 2005. "Equilibrium in a Dynamic Limit Order Market," Journal of Finance, American Finance Association, American Finance Association, vol. 60(5), pages 2149-2192, October.
  9. Pakes, Ariel & McGuire, Paul, 2001. "Stochastic Algorithms, Symmetric Markov Perfect Equilibrium, and the 'Curse' of Dimensionality," Econometrica, Econometric Society, Econometric Society, vol. 69(5), pages 1261-81, September.
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