More than Meets the Eye

LOBs are designed to aggregate all the buy and sell limit orders from patient traders, so that they can be matched with the market orders of more hurried investors. It would therefore be easy to confuse the content of an LOB with the total supply and demand of a given asset at a given time. However, there are many reasons to believe that an LOB only reflects a tiny fraction of the true total supply and demand – which, for the most part, actually remain latent.

One argument for the existence of latent liquidity comes from examining LOB volumes and order flow. Recalling our discussion in Section 10.5, it is not uncommon for large players to seek to buy or sell a substantial fraction (say, a few tenths of a percent up to a few percent) of the total market cap of a given asset. Since the total outstanding volume in the LOB of a typical small-tick stock is roughly 10–3 of the market cap, and since the average daily volume (ADV) of trade is rarely above 0.5% of the market cap, such traders’ execution horizons must be on the scale of days to weeks. Therefore, at any given time, a large component of the supply or demand does not appear in the LOB, but instead reveals itself gradually.

Why do such traders not simply submit very large limit orders to the LOB? By doing so, they could clearly gain substantial queue priority. However, these limit orders would also signal to the rest of the market that a very large trader is present, and would immediately create price impact (remember again the dialogue at the beginning of Chapter 1). For small-tick stocks, this information leakage clearly outweighs the gain in queue priority. For larger-tick stocks, the total volume in the LOB is perhaps ten times larger, but is still just a small fraction of the ADV, so the drawbacks still far outweigh the benefits.

Another argument for the existence of latent liquidity concerns the shape of the LOB. As we saw in Chapter 4, real LOBs exhibit a hump-shape that first increases then decreases with increasing distance from the best quotes, and that eventually decays to zero at large distances.