Strategic trading and learning about liquidity

Many practitioners point out that the speculative profits of institutional traders are eroded by the difficulty in gauging the price impact of their trades. In this paper, we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know the distribution of liquidity (“noise”) trades. Instead, they have to learn about liquidity from past prices and trading volume. This learning implies that strategic trades and market statistics such as informational efficiency are path-dependent on past market outcomes. Our paper also has normative implications for practitioners.     

THE DEALERS' PRICE/SIZE QUOTE AND MARKET LIQUIDITY

We model trading in a competitive securities market where informed traders and liquidity traders transact with dealers. The dealers' entire published quote is modeled: bid-ask prices and the number of shares the dealer is willing to buy/sell at these prices (i.e., size quotes). We argue that size quotes are a more informative indicator of market liquidity than the bid-ask spread's adverse-selection component. Moreover, the size quotes reveal several market characteristics that cannot be inferred from the bid-ask spread's adverse-selection component alone. The model generates a number of empirically testable predictions that clarify certain key elements of market liquidity.     

A theory of the interday variations in volume, variance, and trading costs in securities markets

In an adverse selection model of a securities market with oneinformed trader and several liquidity traders, we study theimplications of the assumption that the informed trader hasmore information on Monday than on other days. We examine theinterday variations in volume, variance, and adverse selectioncosts, and find that on monday the trading costs and the varianceof price changes are highest, and the volume is lower than onTuesday. These effects are stronger for firms with better publicreporting and for firms with more discretionary liquidity trading.     

Dancing in the dark: post-trade anonymity,liquidity and informed trading

We analyze the impact of post-trade anonymity on liquidity and informed trading in an order driven stock market. The German stock market introduced the Central Counterparty (CCP) in March 2003 for German equities traded on its anonymous electronic trading platform Xetra leading to a major change in its existing transparency regime. Before the introduction trader IDs were revealed to the counterparties of a trade, with the introduction of the CCP even after the transaction the traders remain anonymous. Previous theoretical and empirical research documents that pre-trade anonymity results in increased liquidity, while results on post-trade anonymity are mixed. We find a significant increase in liquidity measured through a reduction of 25% in implicit transaction costs. We also document that the arrival rate of informed traders is reduced in the anonymous setting. Following recent findings of Bloomfield et al. (J Finan Econ 75:165–199, 2005) that informed traders take on the role of liquidity providers we interpret our findings as indication that informed traders change their behavior in providing liquidity more aggressively in an anonymous environment.     

Multimarket trading and market liquidity

When a security trades at multiple locations simultaneously,an informed trader has several avenues in which to exploit hisprivate information. The greater the proportion of liquiditytrading by 'large' traders who can split their trades acrossmarkets, the larger is the correlation between volume in differentmarkets and the smaller is the informativeness of prices. Weshow that one of the markets emerges as the dominant locationfor trading in that security. When informed traders can usetheir information for more than one trading period, the timelyrelease of price information by market informed traders expectto make subsequently at other locations. Markets makers, competingto offer the lowest cost of trading at their location, consequentlydeter informal trading by voluntarily making the price informationpublic and by 'cracking down' on insider trading.     

Trade Disclosure,Information Learning and Securities Market Performance

In this paper we examine the effect of information disclosure on securities market performance when liquidity traders are able to acquire information about inside trading. We show that the bid-ask spread increases with the liquidity trader's learning efficiency, which is greater when trade information is disclosed. The bid-ask spread is always higher when trade information is not disclosed. However, the discrepancy between the bid-ask spreads with and without information disclosure narrows when the learning efficiency increases. We also show that the gains of the informed traders in a market without trade information disclosure are reduced in the presence of the liquidity trader's learning. Nevertheless, liquidity traders do not necessarily benefit from increased transparency. In particular, liquidity traders may face higher trading costs.     

Is faster or slower trading better? An examination of order type execution speed and costs

We examine order type execution speed and costs for US equity traders. Marketable orders that execute slower exhibit lower execution costs. Those who remove liquidity faster and pay higher trading costs transact in smaller size, spread trading across more venues, take more liquidity, and are better informed. Nonmarketable limit orders that execute slower exhibit greater adverse selection; and larger, uninformed traders who concentrate their trading in fewer venues submit them. Our findings suggest that slowing down the trading process, when faster options exist, can benefit certain market participants who seek to cross the bid–ask spread.     

Strategic Trading When Agents Forecast the Forecasts of Others

We analyze a multi-period model of trading with differentially informed traders, liquidity traders, and a market maker. Each informed trader's initial information is a noisy estimate of the long-term value of the asset, and the different signals received by informed traders can have a variety of correlation structures. With this setup, informed traders not only compete with each other for trading profits, they also learn about other traders' signals from the observed order flow. Our work suggests that the initial correlation among the informed traders' signals has a significant effect on the informed traders' profits and the informativeness of prices.     

The information content of trading halts

We investigate the impact of trading halts of NYSE-listed stocks on informationally related securities that continue to trade during the period of the halt. Informational relationships are established for companies in the same four-digit SIC industry based on the correlation of returns, volume, volatility, and the adverse selection components of spreads. We find a significant liquidity impact on informationally related securities with spreads and price impact of trades having substantial increases. However, we also find that quoted depths, the number of trades, and trade volume significantly increase. Our results are consistent with the trading halt model of Spiegel and Subrahmanyam [2000. Asymmetric information and news disclosure rules. Journal of Financial Intermediation 9, 363–403] and with the informed trading model of Tookes [2008. Information, trading, and product market interactions: cross-sectional implications of informed trading. Journal of Finance 63, 379–413]. In addition, our results indicate that there is a common liquidity response of informationally related securities to firm-specific trading halts.     

Information dissemination by insiders in equilibrium

This paper generates an equilibrium explanation for partial disclosure of information by an insider to privileged associates. In our model, prices are set by competitive market makers in anticipation of trading volume, but not affected by the actual number of trades. Liquidity demand is not perfectly inelastic, but rather liquidity traders are sensitive to trading costs through a reservation price. Because profits from liquidity traders are bounded, the feasibility of an equilibrium depends on the balance between the number of associates, the precision of information and the number of liquidity traders. Partially, rather than fully, disclosing information alters this balance by limiting the informational advantage of individual associates. If the number of associates is exogenous, partial disclosure prevents market failure. If the insider chooses the number of associates, partial disclosure allows him to serve more associates but still increase total associate profits.     

Informed trading and liquidity in the Shanghai Stock Exchange

Dufour and Engle (J. Finance (2000) 2467) find evidence of increased presence of informed traders when the NYSE markets are most active. No such evidence, however, can be found by Manganelli (J. Financial Markets (2005) 377) for the infrequently traded stocks. This article investigates the issue of informed trading and its relation to liquidity in Shanghai Stock Exchange. Consistent with the hypothesis that information-based trade exists for all stocks, our findings suggest an increased presence of informed trading in both liquid and illiquid stocks when markets are active. Moreover, for the actively traded stocks, our results support the price formation model of Foster and Viswanathan (Rev. Financial Studies (1990) 593) that activities of informed traders deter uninformed investors from trading, thereby reducing market liquidity.     

The impact of competition and information on intraday trading

In a dynamic model of financial market trading multiple heterogeneously informed traders choose when to place orders. Better informed traders trade immediately, worse informed delay – even though they expect the market to move against them. This behavior generates intraday patterns with decreasing spreads, decreasing probability of informed trading (PIN), and increasing volume. We predict that policies that foster market entry improve the welfare of uninformed traders and lead to increased market participation by incumbent traders. Technological advances that lead to better signal processing also encourage market participation and increase volume but at the expense of uninformed traders’ welfare.     

Is there a dark side to exchange traded funds? An information perspective

We examine whether an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component securities. Our tests show an increase in ETF ownership is associated with (1) higher trading costs (bid-ask spreads and market liquidity), (2) an increase in “stock return synchronicity,” (3) a decline in “future earnings response coefficients,” and (4) a decline in the number of analysts covering the firm. Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition. This combination results in less informative security prices for the underlying firms.     

The “make or take” decision in an electronic market: Evidence on the evolution of liquidity

This paper uses experimental asset markets to investigate the evolution of liquidity in an electronic limit order market. Our market setting includes salient features of electronic limit order markets, as well as informed traders and liquidity traders. We focus on the strategies of the traders and how these are affected by trader type, characteristics of the market, and characteristics of the asset. We find that informed traders use more limit orders than do liquidity traders. Our main result is that liquidity provision shifts as trading progresses, with informed traders increasingly providing liquidity in markets. The change in the behavior of the informed traders seems to be in response to the dynamic adjustment of prices to information; they take (provide) liquidity when the value of their information is high (low). Thus, a market-making role emerges endogenously in our electronic markets and is ultimately adopted by the traders who are least subject to adverse selection when placing limit orders.     

The effect of public information and competition on trading volume and price volatility

In a one-period model of market making with many exogenouslyinformed traders, we first show that the variance of pricesand expected trading volume depend on the public informationreleased at the start of trading. This is accomplished by representingbeliefs with elliptically contoured distributions, for whichthe form of optimal decision rules does not depend on the specificdistribution used. Second, if the model is altered so that thedecision to become informed is made endogenous, then the decisionrules of the market-maker and informed traders depend on thepublic information. Third, in a multiperiod model with manyinformed traders and long-lived private information, recursionformulas similar to those of Kyle (1985) hold for all ellipticallycontoured distributions, trading volume is autocorrelated and,unless per period liquidity trading is bounded away from zeroas new trading periods are added, informed traders' profitsvanish.     

Does proprietary day trading provide liquidity at a cost to investors?

Capitalizing on the special case of Malaysia in which proprietary day traders (PDTs) are mandated to boost liquidity and the recent availability of trading data, this paper empirically examines the liquidity effect of proprietary day trading. Using daily data spanning October 2012 to June 2018, we find evidence that PDTs' trade volume is associated with higher aggregate liquidity in the Malaysian stock market, which can be attributed to the theoretical channel of intense competition among informed traders. However, such improved liquidity comes at a cost to investors, as proprietary day trading is found to be associated with higher conditional volatility and conditional skewness of closing percent quoted spreads. The former is due to the exchange-imposed immediacy for PDTs to close their open positions, whereas the latter can be attributed to the exclusive rights granted to PDTs to engage in intraday short selling.     

High-frequency trading: a literature review

The relatively recent phenomenon of high-frequency trading has had a profound impact on the micro-structure of financial markets. Several authors hailed it as a provider of liquidity and a mechanism for controlling volatility, two highly welcome features, especially beneficial to retail traders, whereas other authors view the situation generated by algorithmic trading as damaging for both small and institutional traders, and the orderly functioning of the markets. This paper analyzes the impact of high-frequency trading in respect of the main parameters affecting market quality: volatility, transaction costs, liquidity, price discovery, penalization of slower traders, and impact on sudden financial crises, the notorious flash crashes. As often happens within the financial community, different views stand to each other and no conclusive agreement on the value of most parameters has been reached as yet. A section on the apparently falling profits of high-frequency traders, as denounced in recent times, completes the review.

     

Investor type trading behavior and trade performance: Evidence from the Thai stock market

This paper examines the trading behavior and decomposes the trading performance of foreign, individual and institutional investors as well as proprietary traders in a dynamic emerging stock market, the Stock Exchange of Thailand. Foreign investors follow a positive feedback, momentum strategy and are good short term market timers but have poor security selection performance in poor markets, thus suggesting that they have a macro (market timing) but not a micro (security selection) informational advantage relative to local investors. Institutions and proprietary traders have poor security selection trading performance. Individuals display herding behavior and have fairly good security selection performance, but individual investors appear to compensate proprietary traders for the provision of short term liquidity by proprietary traders, so individuals' security selection gains are canceled out by market timing losses.     

Fuzzy logic,trading uncertainty and technical trading

From the market microstructure perspective, technical analysis can be profitable when informed traders make systematic mistakes or when uninformed traders have predictable impacts on price. However, chartists face a considerable degree of trading uncertainty because technical indicators such as moving averages are essentially imperfect filters with a nonzero phase shift. Consequently, technical trading may result in erroneous trading recommendations and substantial losses. This paper presents an uncertainty reduction approach based on fuzzy logic that addresses two problems related to the uncertainty embedded in technical trading strategies: market timing and order size. The results of our high-frequency exercises show that ‘fuzzy technical indicators’ dominate standard moving average technical indicators and filter rules for the Euro-US dollar (EUR-USD) exchange rates, especially on high-volatility days.