VPIN - A Measure of Liquidity
VPIN stands for Volume Synchronized Probability of INformed Trading, which although a mouthful, is simply a mathematical model used in financial markets to gauge what proportion of trades made in the market at any point in time are informed. This gauge, especially after the flash crashes of 2010 and 2015, have come to be proven as barometer for liquidity levels in the market. Why this is more accurate than volume levels to gauge liquidity I will explain further below.
What is Liquidity
Liquidity is the measure of how likely it is to find a player out there in the market to take the opposite position of your order. If you want to buy 100 shares of Apple, a highly liquid market means that you will be a seller of 100 shares of Apple relatively quickly (someone is readily available to fulfill your order).
Why is Volume a Bad Indicator of Liquidity
Volume is the number of shares that are transacted. It could be a measurement in days, minutes or even seconds. It is commonly assumed that a high volume for a particular stock means there is high liquidity for the stock. However, this is not the case. In the NYSE flash crash of 2010, volume of E-mini S&P stock index future contracts experienced a surge in trading volume. However, if you were to place a sell order on the market during the crash, your order will more likely than not not be fulfilled. This is because the high volume of orders being transacted during the crash are mostly short orders. If your order is a short order as well, then it will struggle to find a buyer since there are so few of them in the market. Hence, volume is not a perfect indicator of liquidity - we need to look at the nature of transactions in the market as well.
But First, Some Semantics
VPIN, in a rough sense, measures the volume of informed trades in the market. To understand what are informed trades, we may first need to distinguish between uninformed and informed traders. Generally speaking, an informed trader is someone who makes a trade based on his own analysis of market or industry conditions etc. An uninformed trader is someone (or more commonly a computer) who simply takes the other side of the trade without bothering about whether it is a financially viable move. Currently, with the rise in high-frequency trading (HFT), most uninformed traders are HFT computers who basically serve as market makers (fulfill orders for the sake of fulfilling orders). They are equipped with safeguards that will be triggered when market prices change too drastically (usually when there is a majority of informed traders in the market, driving the price up in one direction). When these safeguards are triggered, the HFT computers capitulate and dump their positions, exiting the market.
Why is VPIN Better
Since VPIN measures what proportion of players are informed traders (usually it is around 40%), it is a better barometer of when market makers - the underpinning of liquidity in financial markets - are overwhelmed and hence, exit the market. This leads to a viscious cycle of a dearth of liquidity, exacerbating pressures on investors to dump their inventories and driving the flash crashes that we see. In fact, in the hours leading up to minutes before the flash crash of 2010, VPIN rate was at an abnormal high of 80% to 100%. This suggests a gap in market makers - little liquidity.
What Can We Do With VPIN
Most importantly, you can use VPIN to get a sense of market conditions and use it as a warning tool for when things are about to go south. For the risky investor, you can also monetize the conditions that are about to come with high VPIN values. For instance, taking the opposite side of the crash and profiting off the future recovery. With that being said, such flash crashes, although they happen several times a year on average, are not a sustainable way to profit and there are definitely more hygienic ways to earn consistent income and prevent your funds from being leveraged too hard.