Market Depth and Order Size - An Analysis of Permanent Price Effects of DAX Futures' Trades

In this paper we analyze the permanent price impact of trades in financial markets by investigating the relation between unexpected net order flow and price changes. We mainly focus on four questions. Does large order flow convey more information than small order flow? Does net buy and net sell volume convey the same amount of information? Does the information content of order flow increase linearly with its size? Are there alternative measures of trading activity which convey more information than order flow?

We use intraday data on German index futures (DAX futures). Our analysis based on a neural network model provides us with the following results. Firstly, the information content of order flow increases with its size. Secondly, we find that buyer initiated trades and seller initiated trades do not differ with respect to their information content. Thirdly, the relation between net order flow and price changes is strongly non-linear. Large orders lead to relatively small price changes whereas small orders lead to relatively large price changes. Finally, net order flow measured as contracts traded offers the best explanation for price changes. Net number of trades explains price changes almost as well. However, the relative net order flow, i.e. net order flow divided by volume, does not provide the same level of explanation. The results are found to be quite robust with respect to the estimation procedure.

Overall, the results of our paper suggest that the assumption of a linear impact of orders on prices (which is often used in theoretical papers) is highly questionable. Thus, market depth cannot be described sufficiently by a single number. Therefore, empirical studies, comparing the depth of different markets, should be based on the whole price impact function instead of a simple ratio. To allow the market depth to depend on trade volume could open promising avenues for further theoretical research. This could lead to quite different trading strategies as in traditional models.

Kempf, Alexander and Olaf Korn (1998), Market Depth and Order Size - An Analysis of Permanent Price Effects of DAX Futures' Trades, ZEW Discussion Paper No. 98-10, Mannheim.