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The definition of micro-price is

S = Pa * Vb / (Va + Vb) + Pb * Va / (Va + Vb)

where Pa is the ask price, Va is the ask volume, Pb is the bid price, and Vb is the bid volume.

The typical explanation for micro-price is that a larger quantity of shares on the bid than on the ask indicates greater buying pressure, and therefore the "true" price is closer to the ask than to the bid.

But my confusion is: The bid price should be hit by the aggressive sell orders, so the "true" price should still be closer to bid, opposite to the definition of micro-price.

Could anyone help to explain?

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  • $\begingroup$ You are right, but nobody knows if aggressive market sell or market buy orders are about to hit or not. If all we can observe is the limit order book, it makes sense to assume that the market buy/sell orders that will arrive are going to be roughly matched and use the quantities at the bid and ask to try to predict which way the price is going to go. It is only a heuristic; a big market sale can cause the price to go down even though the bid queue is much bigger than the ask queue. A comparison of the queues on both sides only tells you which side is more vulnerable, not who is going to win. $\endgroup$
    – nbbo2
    Commented Jan 11, 2020 at 16:37
  • $\begingroup$ @noob2 Thanks. So you both agree with and disagree with the definition of microprice. But then why do people still use such definition to build their trading algorithm? $\endgroup$
    – olivia
    Commented Jan 12, 2020 at 2:35

2 Answers 2

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The justification for that microprice is empirical, not theoretical. In most market I can think of, most of the time, if there are more orders and more size on the bid than the ask, then it's more likely that that BBO will tick up rather than down. And the greater the imbalance, the higher the probability of an uptick (and vice-versa for downticks). For your market, you can grab some tick data to verify this. If you work in HFT, then you'll likely spend a good amount of time looking at tick data and trying to come up with a better formula than the one you describe (there are lots of ways to improve it).

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  • $\begingroup$ can you please describe one? $\endgroup$
    – nimbus3000
    Commented Jan 13, 2020 at 9:56
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    $\begingroup$ An obvious improvement is to include orders deeper in the book than just the BBO. $\endgroup$
    – Marc Shivers
    Commented Jan 14, 2020 at 12:46
  • $\begingroup$ It add a lot to the noise, makes the output very close to useless the way I have been using it. Is it possible for you to share some insights? $\endgroup$
    – nimbus3000
    Commented Jan 14, 2020 at 15:13
  • $\begingroup$ what have you tried? $\endgroup$
    – Marc Shivers
    Commented Jan 15, 2020 at 13:39
  • $\begingroup$ I have used top 3, 5 levels, all level on both sides of the book, a lot of noise. $\endgroup$
    – nimbus3000
    Commented Jan 16, 2020 at 4:48
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From my own experience, if there is significantly more size on the bid than the ask, then it is easier for market participants to clear the remaining asks than to clear the remaining bids.

This phenomenon is, of course, not absolute or automatic. But it happens more than half the time, which is the whole point of a weighted average like this. There is a greater than 50-50 chance that the price will rise, so we want a value that is higher than the standard mid.

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