How do Extreme Price Movements End? (with Jonathan Brogaard and Konstantin Sokolov)

Abstract: We test competing theories on liquidity dynamics during extreme price movements (EPMs). Contrary to a widespread concern that market making constraints cause liquidity deterioration during EPMs, our findings are in line with the theory of strategic liquidity provision – market makers strategically allow for price pressures and earn compensation from pricing errors. As a result, towards the end of an average EPM liquidity provision intensifies. EPMs ending with more liquidity supplied absorb more directional demand. In some cases, active liquidity suppliers act as contrarian liquidity demanders and mitigate more price pressures. Finally, we find that market makers have higher incentives to supply liquidity during EPMs around earnings announcements or in less tick-constrained stocks.