71 Pages Posted: 23 Oct 2010 Last revised: 15 Apr 2012

Date Written: February 20, 2012

Abstract

Order flow is toxic when it adversely selects market makers, who may be unaware they are providing liquidity at a loss. We present a new procedure to estimate flow toxicity based on volume imbalance and trade intensity (the VPIN toxicity metric). VPIN is updated in volume-time, making it applicable to the high frequency world, and it does not require the intermediate estimation of non-observable parameters or the application of numerical methods. It does require trades classified as buys or sells, and we develop a new bulk volume classification procedure that we argue is more useful in high frequency markets than standard classification procedures. We show that the VPIN metric is a useful indicator of short-term, toxicity-induced volatility.