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What really causes large price changes?

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  • J. Doyne Farmer
  • Laszlo Gillemot
  • Fabrizio Lillo
  • Szabolcs Mike
  • Anindya Sen

Abstract

We study the cause of large fluctuations in prices in the London Stock Exchange. This is done at the microscopic level of individual events, where an event is the placement or cancellation of an order to buy or sell. We show that price fluctuations caused by individual market orders are essentially independent of the volume of orders. Instead, large price fluctuations are driven by liquidity fluctuations, variations in the market's ability to absorb new orders. Even for the most liquid stocks there can be substantial gaps in the order book, corresponding to a block of adjacent price levels containing no quotes. When such a gap exists next to the best price, a new order can remove the best quote, triggering a large midpoint price change. Thus, the distribution of large price changes merely reflects the distribution of gaps in the limit order book. This is a finite size effect, caused by the granularity of order flow: In a market where participants placed many small orders uniformly across prices, such large price fluctuations would not happen. We show that this explains price fluctuations on longer timescales. In addition, we present results suggesting that the risk profile varies from stock to stock, and is not universal: lightly traded stocks tend to have more extreme risks.

Suggested Citation

  • J. Doyne Farmer & Laszlo Gillemot & Fabrizio Lillo & Szabolcs Mike & Anindya Sen, 2003. "What really causes large price changes?," Papers cond-mat/0312703, arXiv.org, revised Apr 2004.
  • Handle: RePEc:arx:papers:cond-mat/0312703
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    1. Enrico Scalas & Rudolf Gorenflo & Hugh Luckock & Francesco Mainardi & Maurizio Mantelli & Marco Raberto, 2004. "Anomalous waiting times in high-frequency financial data," Quantitative Finance, Taylor & Francis Journals, vol. 4(6), pages 695-702.
    2. Marco Raberto & Enrico Scalas & Rudolf Gorenflo & Francesco Mainardi, 2000. "The waiting-time distribution of LIFFE bond futures," Papers cond-mat/0012497, arXiv.org.
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