Market Microstructure

Overview

Study the micro-level mechanisms of price formation: who is trading, how they are trading, and how trades affect prices. For quantitative strategies, this matters because it improves transaction-cost estimation, identifies informed trading, and optimizes execution.

Applicable scenarios:

• Precise estimation of strategy trading costs (instead of simply assuming a flat 0.1% fee)
• Designing large-order execution strategies (TWAP / VWAP / IS)
• Detecting order-flow toxicity (avoid time windows dominated by informed traders)
• Quantifying liquidity risk (flash-crash warning)
• Capturing China A-share-specific microstructure features (call auction / closing auction / block trades)

Core Concepts

Bid-Ask Spread

Three measurements:

Metric	Formula	Meaning
Quoted spread	Ask - Bid	Best spread shown in the limit order book
Effective spread	`2 ×	trade price - mid price
Realized spread	2 × direction × (trade price - mid price 5min later)	True market-maker profit

China A-share example:
  Instrument: 600519.SH Kweichow Moutai
  Best bid: 1680.00  Best ask: 1680.50
  Quoted spread: 0.50 RMB = 0.03%

  Instrument: 000001.SZ Ping An Bank
  Best bid: 11.05  Best ask: 11.06
  Quoted spread: 0.01 RMB = 0.09%

Spread decomposition (Roll):
  Spread = adverse-selection cost + inventory cost + order-processing cost
  In China A-shares: adverse selection accounts for 60-70% (mixture of retail and informed traders)

Spread drivers:
  - Larger market cap -> smaller spread (Moutai 0.03% vs small-cap 0.5%)
  - Higher volatility -> wider spread (market-maker risk premium)
  - Higher volume -> narrower spread (greater competition)
  - Higher information asymmetry -> wider spread (adverse selection)

Order-Flow Toxicity Metrics