What really causes large price changes?

We study the cause of large fluctuations in prices in the London Stock
Exchange. This is done at the microscopic level of individual events, where an
event is the placement or cancellation of an order to buy or sell. We show that
price fluctuations caused by individual market orders are essentially
independent of the volume of orders. Instead, large price fluctuations are
driven by liquidity fluctuations, variations in the market's ability to absorb
new orders. Even for the most liquid stocks there can be substantial gaps in
the order book, corresponding to a block of adjacent price levels containing no
quotes. When such a gap exists next to the best price, a new order can remove
the best quote, triggering a large midpoint price change. Thus, the
distribution of large price changes merely reflects the distribution of gaps in
the limit order book. This is a finite size effect, caused by the granularity
of order flow: In a market where participants placed many small orders
uniformly across prices, such large price fluctuations would not happen. We
show that this explains price fluctuations on longer timescales. In addition,
we present results suggesting that the risk profile varies from stock to stock,
and is not universal: lightly traded stocks tend to have more extreme risks.