Flow toxicity of high‐frequency trading and its impact on price volatility: Evidence from the KOSPI 200 futures market

Abstract

We examine the relations among high frequency trading, flow toxicity, and short-term volatility during both normal and stressful times. Using transaction data from the KOSPI 200 futures market, we find that the volume-synchronized probability of informed trading (VPIN) well measures flow toxicity in that it strongly predicts short-term volatility. We further show that high frequency trading is negatively related to VPIN and short-term volatility in normal times, but turns to be positively related in stressful times. Finally, we advocate to use bulk volume classification (BVC) by presenting evidence that the initiator identified by BVC trades at more favorable prices than the true trade initiator.

High-Frequency Trading and its Impact on Market Liquidity: A Review of Literature

“…HFTs are extremely fast traders who build their algorithms in parallel with their experience and skills. Although very few studies distinguish between individual and institutional highfrequency traders, an exceptionally large portion of low latency traders are within HFT firms (Jarnecic and Snape, 2014;Brogaard and Garriott, 2019;Kang et al, 2020). Thus, the change in their trading behavior from liquidity suppliers to liquidity demanders may be associated with their extremely fast information processing capabilities and well-established, risk-averse and profit maximizing strategies.…”

“…Easley et al (2011) point out to CFTC-SEC report and acknowledge the tie between the Flash Crash and HFTs who liquidated positions and left the market only after the order flow toxicity increased. 7 Hautsch et al (2017) and Kang et al (2020) argue that HFTs take a position in the same direction with other agents in the course of extreme events. Kang et al (2020) further distinguish between foreign and domestic HFTs and exploit the dissimilarities between two investor groups with respect to their trading activities' impact on order flow toxicity.…”

“…7 Hautsch et al (2017) and Kang et al (2020) argue that HFTs take a position in the same direction with other agents in the course of extreme events. Kang et al (2020) further distinguish between foreign and domestic HFTs and exploit the dissimilarities between two investor groups with respect to their trading activities' impact on order flow toxicity. They observe that while domestic and foreign HFTs have a difference in 'normal times', they both produce toxic orders during extreme periods.…”

“…The first factor suggested in this study explains much of this phenomenon. A significant part of the documented liquidity related externalities of HFT as well as the controversy in findings tend to arise through negative market conditions, i.e., extreme price movements (e.g., Brogaard et al, 2018) and intraday shocks and crashes (e.g., Kang et al, 2020;Golub et al, 2012;Johnson et al, 2013;Leal et al, 2016). Similarly, the latter factor, which comprises the characteristics of the HFT liquidity provision, helps explain the controversy in findings.…”

Who and what drives informed options trading after the market opens?

“…In addition to investor types, investor frequency may be related to the information advantage. Recently, high-frequency traders have taken up a significant portion of the financial markets, and their trading activities are known to affect the market differently from low-frequency traders (Brogaard et al, 2018;J. Kang et al, 2020;Kirilenko et al, 2017).…”