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The bid-ask bounce is the bouncing of trade prices between the bid and ask sides of the market. It introduces a systematic bias to the data which can cause serious problems in analysis.

What methods can be used to control for the bid/ask bounce when using high-frequency data? One approach is to use the bid/ask midpoint, but what about with trade data? Even using n-minutely VWAP prices doesn't guarantee that you won't have spurious mean-reverting behavior.

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  • $\begingroup$ Given sufficient liquidity, I just mark positions to mid; the last trade price can highly variable. $\endgroup$ – chrisaycock Jun 23 '11 at 13:48
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Why not just use the weighted mid-market price, quoted as (Bsize * Aprc + Asize * Bprc) / (Asize + Bsize)? This measure doesn't suffer a bounce per se and allows you to directly take moving or exponential moving averages.

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  • $\begingroup$ Thanks. Weighted mid-price is the best approach that I can find. $\endgroup$ – Shane Jan 1 '13 at 19:27
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    $\begingroup$ @Foo, can you comment why prices are weighted by amount of another side? I could not find any information about it. Or it is a typo? $\endgroup$ – Ilya Aug 28 '13 at 8:16
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    $\begingroup$ @Ilya That's not a typo. When there are many buyers, they repeatedly hit the ask price, lowering the available ask size. So we weight the bid less heavily, and the weighted price rises. Likewise, when sellers arrive, the weighted price falls. $\endgroup$ – pteetor Oct 22 '13 at 20:00
  • $\begingroup$ I've also seen this measure referenced as the "micro price". I am not sure when this first appeared in the literature though. $\endgroup$ – Guilherme Salomé Jan 10 '18 at 18:58
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IMO transaction data is a better approach, because you have both sides of the trade agreeing that the price is "right." The literature tends to decompose the transaction price $P$ into a true/efficient price $P^e$ plus micro-structure noise, which I think originates from Hasbrouck '93 in the Review of Financial Studies. So you end up with something like $$P^e_t = P^e_{t-1} + \nu$$ and $$P_t = round(P^e_t + c_t Q_t, d)$$ where $\nu \sim N(0, \sigma^2_t)$, $c_t > 0$, $Q_t \in \left\{-1, 1 \right\}$, and $d$ is the tick size. Note that $c_t$ provides the spread and $Q_t$ tells you if the transaction is buyer or seller initiated (typically determined with the "Lee-Ready algorithm"). I found this particular presentation in a 2002 working paper from Engle and Russell (edit: titled Analysis of High Frequency Data); I think this is pretty standard and you can probably find a good deal of research that tries to provide $c_t = f(\cdot)$. It looks like a Andersen, Bollerslev, and Diebold have a 2007 NBER working paper (edit: titled Roughing it Up: Including Jump Components in the Measurement, Modeling and Forecasting of Return Volatility) that provides a more thorough treatment of these ideas.

When you're dealing with (ultra) high-frequency data you also have the problem of time to transaction. Engle has a 2000 Econometrica paper (edit: titled The Econometrics of Ultra-High-Frequency Data) in which he describes how to account for time to transaction, but he's using bid-ask midpoints, not transactions.

I don't have any first-hand experience to know if using the midpoint is a bad assumption in practice, but the 2000 and 2007 papers should be a good start.

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  • $\begingroup$ can you please provide the title of the papers you cite? Most of the links in this answer are dead;( $\endgroup$ – user189035 Oct 24 '16 at 12:29
  • $\begingroup$ I assume the next to last link is to 'Roughing it Up: Including Jump Components in the Measurement, Modeling and Forecasting of Return Volatility' ungated copy $\endgroup$ – user189035 Oct 24 '16 at 13:58
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    $\begingroup$ @user189035 -- Yes, I haven't looked at this in a long time, but it looks like section 3 of the Andersen et al paper talks about microstructure noise. Five and half years later there are probably better references, though. $\endgroup$ – Richard Herron Oct 24 '16 at 14:44
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    $\begingroup$ thanks for having taken the time. Do you think you could recall the title of ' 2002 Engle and Russell' paper? This is the reference I think I would be more interested: the Andersen et al doesn't mention the Lee and Ready algorithm which is the part of your answer I am most interested in;) $\endgroup$ – user189035 Oct 24 '16 at 14:48
  • $\begingroup$ @user189035 I added the titles when I updated yesterday. And I think that I have more survivable links, too. $\endgroup$ – Richard Herron Oct 25 '16 at 17:40
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You don't say what it is that you do with trade data that is made difficult by the bid-ask bounce.

If it's for the purpose of establishing the price at which you can trade and it's at a frequency where the bid-ask bounce is a problem, then I think having realistic execution assumptions is the way to go. In particular this means that you should be mainly looking at quotes rather than trades in order to establish prices.

For most other applications that I can think of, either smoothing or reducing the frequency of the data seem the way to go.

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  • $\begingroup$ Do you happen to know of any papers that discuss this? $\endgroup$ – Shane Jun 23 '11 at 9:53

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