Commonality in Order Flow: Its Sources and Its Effects on Trading Costs and Returns
Jarrad Harford, University of Washington
Aditya Kaul, University of Alberta

We examine the pervasiveness of common order flow in the stock market, propose a hierarchy of sources comprising broad market, indexing and industry effects, and evaluate the explanatory power of these sources. Finally, we assess the economic relevance of these sources by studying their impact on trading costs and returns. Stocks show significant pairwise correlations in order flow, which have increased over time. These correlations are substantially larger for stocks in the most common index, the S&P 500. Order flow for individual S&P stocks is affected positively by aggregate S&P order flow and lagged returns. Smaller, though significant, broader market and industry effects are also discernible in order flow for all stocks. Returns and trading costs are positively correlated across non-S&P stocks and more strongly so across S&P stocks. Returns and trading costs for both samples vary with aggregate S&P and non-S&P order flow, suggesting that specialists can identify periods when basket trading is heavy. The documented effects are most striking for medium trades and at the end of the day. Importantly, the pairwise order flow, trading cost and return correlations become negligible after accounting for common factors. Overall, our evidence is consistent with the hypotheses that (a) while market-wide effects are also relevant, indexing has an especially important role in creating economically significant effects through common order flow and (b) these commonalities manifest themselves through institutional transactions. (Accepted Spring 2002.)