Finding Alphas, 2nd Edition

26Intraday Data in Alpha Research

By Dusan Timotity

The dynamics of liquidity, transaction price uncertainty, the structure of the order book, and the formation of the bid–ask spread all contribute significantly to the performance of alphas. These patterns affect the realized return most trivially via the effects of trading turnover – the channel referred to as impact – but they also have indirect effects on alpha performance and can themselves be sources of alpha signals, through characteristics related to the intraday dynamics of the traded assets. Collectively, these properties of the asset market define the market microstructure.

Research in market microstructure, as its name suggests, aims to capture the structure of investors by separating distinct classes that differ in their behavior or motivation for trading. Since the milestone paper of Glosten and Milgrom (1985), a wide variety of microstructural patterns has been discovered and documented to significantly affect the expected returns of assets. In their pioneering results, the authors derived how bid–ask spreads are formed in equilibrium; this is highly important in the analysis of the after-cost performance of alphas. Before going into details, we first define the topic-specific terminology, such as liquidity, the bid–ask spread, and the order book, and clarify the differences between quote- and order-driven markets. Second, we discuss the notion of the illiquidity premium that stands for the positive relationship ...