# 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, 2021 at 14:16
– Pleb
Jan 7, 2021 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, 2021 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, 2021 at 12:42

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)