Measuring informed trading risk: a 3-decade problem in empirical financial economics.
My paper "Detecting Informed Trading Risk from Undercutting Activity", joint with Peter Dixon and Qiyu Liu, addresses a longstanding issue in financial economics: the empirical measurement of informed trading presence. Strategic considerations of informed investors dictate that they conceal their trading intents. However, other market participants often strive to avoid trading with informed investors to avoid adverse selection. This makes measurement of informed trading presence inherently difficult, yet important, which has led leading academic journals to publish several articles proposing measures of informed trading probability/intensity.
My co-authors and I propose a simple, intuitive, and easy-to-construct measure of informed trading risk. Existing measures primarily try to predict and/or exploit how informed investors consume liquidity, proposing empirical measures that are computationally demanding or require non-standard data. In contrast, we examine how the presence of informed affects liquidity supply in limit order markets. We observe that, when faced with increased risk trading against informed marketable orders, liquidity providers compete less to get their limit orders to the front of the order-book queue. Given the competitive nature of modern order-driven markets, this behavior leads to reductions in "undercutting" activity, relative to its normal levels, leaving easily observable footprints in standard trade and quote data. We introduce a measure of undercutting activity QID, which we the use to construct unexpected undercutting times -1, dubbed QIDres, to capture informed trading risk.