Order imbalance and individual stock returns: Theory and evidence

This paper studies the relation between order imbalances and daily returns of individual stocks. Our tests are motivated by a model which considers how market makers dynamically accommodate autocorrelated imbalances emanating from large traders who optimally choose to split their orders. Price pressures caused by autocorrelated imbalances cause a positive relation between lagged imbalances and returns, which reverses sign after controlling for the current imbalance. We find empirical evidence consistent with these implications. We also find that imbalance-based trading strategies yield statistically significant returns. Our results shed light on the role of inventory effects in daily stock price movements. (C) 2003 Elsevier B.V. All rights reserved.