Which is Limit Order Traders More Fearful of: Non-Execution Risk or Adverse Selection Risk'

Abstract

Limit orders are subjected to two types of risks: non-execution risk and adverse selection risk. The fear of each of these two types of risk may lead limit order traders to different actions. On one hand, limit order traders can mitigate non-execution risk by canceling limit orders with low probability of execution and resubmitting them in front of their cancelled orders in the limit order book (by pricing the limit orders more aggressively). On the other hand, they can mitigate adverse selection risk by canceling the limit orders at risk and resubmitting them further behind in the limit order book (by pricing the limit orders less aggressively). In this paper, the decisions of limit order traders are tracked from limit order submission to cancellation, and from cancellation to resubmission. The paper also analyzes the impact of factors, that may affect the risks of limit order trading, on the decisions of the limit order traders to cancel their limit orders, to resubmit their limit orders after cancellation, and where in the limit order book (relative to their cancel orders) to resubmit their limit orders if they chose to resubmit. Both static and dynamic variables are considered. The results show that limit order traders are generally more concerned with non-execution risk than adverse selection risk, except when trading in the least active stocks. The paper also shows that nearly 40 percent of limit orders are cancelled and most of these limit orders never re-enter the market after cancellation. In other words, liquidity leakage through order cancellations is rarely replenished by the same traders. Variables such as spreads are shown to impact liquidity in two ways: influencing cancellation decisions and resubmission decisions of limit order traders.