Forecasting Prices in the Presence of Hidden Liquidity

Bid and ask sizes at the top of the order book provide information on short-term price moves. Drawing from classical descriptions of the order book in terms of queues and orderarrival rates (Smith et al (2003)), we consider a diffusion model for the evolution of the best bid/ask queues. We compute the probability that the next price move is upward, conditional on the best bid/ask sizes, the hidden liquidity of the market and the correlation between changes in the bid/ask sizes. The model can be useful, among other things, to rank trading venues in terms of the “information content” of their quotes and to estimate the hidden liquidity in a market based on high-frequency data. We illustrate the approach with an empirical study of a few liquid stocks using quotes from various exchanges. ∗Courant Institute, New York University and Finance Concepts LLC †Stern School of Business, New York University ‡Cornell Financial Engineering Manhattan, corresponding author, email: [email protected]