The option value of the limit order book

Abstract

There have been a number of investigations of the individual characteristics of the limit order book (Lee, Mucklow. and Ready. 1993: Harris, 1994 ; Bruno, Hillion, and Spatt, 1995) Lee, Mucklow and ready report that low depths accompany wide spreads and that spreads widen and depths fall in response to higher volume Harris (1991) however suggests a positive relationship between spreads and depth during normal trading periods. Based on the approach of Copeland and Galai ( 1983) and Brenner and Subrahmanyam (1988), we calculate the option value of the limit order book for four snapshots each day (11 00, 12 00, 14:30 and 15:58) for thirty firms listed on the Australian Stock Exchange This approach enables us to consider the spread and depth of the limit order book simultaneously. We find that the option value of the limit order book is stable from day to day, with changes in value due to changes in spreads offsetting those due to changes in depth. We find that the option value of the limit order book is lowest at 11 00 when the relatively higher bid/offer sizes do not offset the, wider spreads. The option value of the limit order book increases throughout the trading day and almost 80% of the option value of the limit order book is concentrated at the best bid and ask.