Limit Orders and the Bid-Ask Spread

This study shows that limit-order traders play a significant role in the market-making process. We find that the majority of bid-ask quotes on the NYSE reflects the trading interest of limit-order traders. We find that specialists tend to quote more actively for low-volume stocks and during early hours of trading when there are fewer limit orders submitted, suggesting that specialists step up to provide liquidity when the level of liquidity supplied by limit-order traders is low. We find that the spread is widest when both the bid and ask prices are quoted by specialists alone, and narrowest when both sides of the quote originate from the limit-order book, suggesting that competition from limit-order traders has a significant effect on spreads. We present a finer test of specialist models of spreads by using only those quotes which reflect the trading interest of specialists. Our empirical results suggest that information models of spreads are the ones that are most consistent with the observed intraday pattern of specialist spreads. Our findings also suggest that the U-shaped intraday pattern of spreads largely reflects the intraday variation in spreads established by limit-order traders