The information content of the limit order book: evidence from NYSE specialist trading decisions

Specialists compete with limit order traders to provide liquidity at the New York Stock Exchange. Since specialists see all system limit orders, they enjoy a unique advantage in this competition. We examine whether the limit order book is informative about future price changes and whether specialists use this information when trading. We use order quantities as well as option values to capture the information content of the limit order book. Our analyses consider three actions specialists can take when a market order arrives: stop the order, immediately fill the order at the quoted price, or immediately fill the order at an improved price. Using SuperDOT limit orders in the TORQ database, we find that the limit order book is informative about future price movements. We also find that specialists use this information in ways that favor them (and sometimes the floor community) over the limit order traders. The results are more evident for active stocks where the competition between specialists and limit order traders is more intense. Moreover, we find strong evidence that specialists in lower-priced stocks are less likely to initiate such actions because of the large relative tick size.