Mechanism for Tick Rule for Trade Classification

I see a few papers using the following tick test to classify a trade as buy/sell initiated trades: compare a trade price to the previous differing trade price, if the current price is higher/lower, then it is a buy/sell.

This method is easy to implement but I do not understand the reason behind it: is there any fundamental mechanism that makes it more likely to be correct?

This is a quantifiable way to infer some understanding of the trade direction under very short time horizons (market microstructure). There exists a couple of other trade direction algorithms, which is neatly described in this paper.

• I understand this is one of the methods to classify trade direction, but I'm interested in understanding why this is a reasonable method just from its mechanism/hypothesis instead of "it just works". Jan 6 at 14:16
• In general, a stock is based around buyers and sellers, where the bid and ask are the best potential prices that buyers and sellers are willing to transact at: the bid for the buying side, and the ask for the selling side. However, transaction prices (which the tick rule is based on) is the last trade that happened: either a potential buyer is willing to pay the asking price, or a potential seller is willing to accept the bid price (they can also meet in the middle if both change their orders). If you only have access to trade-data, you cannot see who initialized the trade.
– Pleb
Jan 7 at 11:50
• From a perspective of providing empirical research, we need to observe whether the transactions was buyer-initiated or seller-initiated, in order to model the "order-flow dynamics" (eg. order imbalances). The tick-rule is one way of assigning trades (which you have defined above). The trade direction overall tells us whether we are in a "buyers market" or "sellers market" where both markets have differing order-flow dynamics. I'm not completely sure if this answers your question.
– Pleb
Jan 7 at 12:01
• I'll elaborate a bit more on the tick rule. Based on intuition, the mechanism of tick rule can be described as follows: The transaction price is between the bid and ask price, and if a buyer places a market order he would get filled by the best asking prices, thus driving the price of the stock up (and the transaction price), and vice versa if he was a seller. Therefore, checking the current transaction price with the former is a good way to indicate whether the transaction was performed by a buyer (current $>$ previous) or a seller (current $<$ previous).
– Pleb
Jan 7 at 12:42
• so basically you mean: suppose we have a fixed quote, then the buy trade will be at ask and the sell trade will be at bid, hence under this simplified case the buy trade price > sell trade price. Therefore a buy trade price is more likely to be higher than the last trade price, and the sell trade price is more likely to be lower than the last trade price. Jan 10 at 2:47

In an order-by-order depth-of-book feed, the trade direction is based on the taking order. If an incoming BUY order is immediately matched with a standing SELL order, the direction is BUY.

Things get a bit more interesting with icebergs and auction orders, in which case the trade direction is typically opposite of the earliest of the two originating orders.

Iceberg example:

time,num,price,quantity,direction
.001,001,20.00,100,B (100 display of 300 iceberg order, 200 hidden)
.002,002,15.00,300,S
.002,003,15.00,100,B (100 display of 300 iceberg order, 100 hidden)
.002,004,15.00,100,B (100 display of 300 iceberg order, 0 hidden)