Ch 1,2 - Intro and Stories

The purpose of these summaries is to help you understand the theory and practice of trading in exchange markets and dealer networks. When you master this subject, you will be able to trade more effectively, you will better appreciate the organization of our markets, and you will be able to form well-reasoned opinions about how the markets should be organized.

Markets have changed substantially during the last 100 years, and they will continue to change in the next 100 years. The current pace of change is fast, and is accelerating. By the time you read this, some specific descriptive information in this book will undoubtedly be dated. The economic principles governing markets and the traders in them, however, will remain the same. These concepts will help you understand all markets—past, present, and future.

CH 3 - The trading industry

The trading industry consists of traders who trade instruments in regulated markets. This short introduction has identified the traders, instruments, markets, and regulators who operate in this industry.

Although our discussions describe how the trading industry is organized, we have hardly considered why it is organized as it is. In subsequent chapters, we will increasingly examine why things are as they are. This introduction to the trading industry should provide you with the background for more interesting discussions to come.

• The buy side buys liquidity services. The sell side provides them.

• Dealers trade for their own account. Brokers trade for others.

• Stocks get more attention than their values would indicate.

• Many markets compete for order flow.

• Exchanges often compete with brokerages to arrange trades.

• Legislatures, regulatory agencies, and SROs regulate the markets. Legislatures provide the regulatory framework, the SROs provide the details, and governmental regulatory agencies provide oversight.

• Private regulators try to create respected standards.

CH 4 - Orders and Order properties

Traders use orders to communicate their intentions to the brokers and exchanges that arrange their trades. The most important and most common order types are market orders and limit orders. Traders use market orders when they want to trade immediately at the best price the market will bear. They use limit orders when they want to place limits on the prices at which they are willing to trade.

Orders differ by their associated uncertainties. Traders who use market orders are uncertain about the prices at which they will trade. Conversely, traders who use limit orders are uncertain about whether they will trade.

Orders also differ by whether traders use them to supply or demand liquidity. Traders who use limit orders grant trading options to the market because they allow other traders to trade when they want to. Limit order traders therefore supply liquidity to the market. Traders who exercise these options take liquidity. Traders generally use market orders when they want to take liquidity. Table 4-4 provides a summary of the properties of the various orders considered in this chapter.

Since limit orders typically supply liquidity and market orders typically demand liquidity, we must understand how traders make their order submission decisions in order to understand the origins of market liquidity. In future chapters, we will carefully consider how traders make these decisions.

• Traders use stylized order instructions to reduce communication errors.

• Market order traders demand immediacy.

• The bid/ask spread is the cost of immediacy for small market orders.

• Large market orders can have substantial and unpredictable price impacts.

• Limit order traders supply liquidity by granting trading options to other traders.

• Limit order traders who must fill their orders can lose substantially if their orders do not fill when the market moves away from them.

• Some traders use limit orders to participate in the market when they are not present.

• Stop orders are not limit orders.

• Stop orders tend to destabilize prices.

CH 5 - Market Structures

Market structures differ widely across markets. The differences determine how the markets operate, who can supply liquidity, who knows current market conditions best, and who can act first. Market structure therefore affects market liquidity, transaction costs, and price efficiency. These factors help determine who will trade profitably.

Markets differ most in how they arrange trades. In quote-driven markets, dealers arrange all trades and provide all liquidity. In order-driven markets, traders or electronic trading systems arrange trades by matching public orders. In brokered markets, brokers arrange trades by finding traders who are willing to trade.

Markets differ significantly in when and where they trade. Call markets trade only when the market is called. Continuous markets trade whenever the market is open. Physically convened markets trade on exchange floors. In distributed access markets, traders trade from their offices.

Markets also differ in how traders negotiate with each other. In screen-based markets, traders communicate through electronic data systems. In oral auctions, traders negotiate their trades by yelling to each other on an exchange floor. In other markets, traders negotiate over the telephone.

Finally, markets differ in their transparency. Transparent markets allow traders to see all orders, quotes, and trades as they occur. In opaque markets, many traders never see this information.

Traders, regulators, and academics often passionately debate which structure is best for a market. The great diversity in existing market structures suggests that good answers to this question may be complex. The best structure for a given market undoubtedly depends on the instrument, on why people want to trade it, and on the communications and computing technologies that traders can use to trade it.

To form a reasoned opinion about the best structure for a market, you must thoroughly understand how markets operate, why people use them, and what traders do in them. These are the main objectives of this book. In the last part of this book, we will return to the question of which market structures are best.

• Call markets convene all traders at the same time and place.

• Continuous markets arrange trades when willing buyers arrive and find waiting sellers, or when willing sellers arrive and find waiting buyers.

• Dealers supply all liquidity in pure quote-driven markets. Public traders and dealers supply liquidity in order-driven markets. Public traders supply liquidity in brokered markets.

• Order-driven markets arrange trades by applying a set of rules to a set of orders.

• Brokers arrange trades by searching for willing traders in brokered markets.

• Access to information about orders and trades is extremely valuable to traders.

• Public traders generally favor transparent markets.

CH 6 - Order Driven Markets

Order-driven markets include oral auctions, single price auctions, continuous rule-based auctions, and crossing networks. These markets use order precedence rules to match buyers to sellers, and trade pricing rules to price the resulting trades.

The trading rules are very important. They affect how traders behave, and they determine who has power and privilege in the market. Since these rules affect how traders form their order submission strategies, they greatly influence whether traders decide to supply or take liquidity.

The first precedence rule at all markets is the price priority rule. This rule encourages traders to bid high and offer low. Various secondary precedence rules then follow. Time precedence rules encourage traders to submit their orders early. In conjunction with price priority, time precedence rules also encourage traders to bid high and offer low. Display precedence rules encourage traders to display their orders. Public order precedence rules give power to public traders over exchange members. Depending on the market, size precedence rules may give precedence to large traders or to small traders.

Trade pricing rules vary by market type. Continuous trading auction markets use the discriminatory pricing rule. This rule favors large liquidity-demanding traders over small liquidity suppliers. Single price auctions use the uniform pricing rule. This rule gives power to small liquidity suppliers at the expense of large traders. Crossing networks use the derivative pricing rule. This rule favors well-informed traders over uninformed traders, and market manipulators over weak and honest traders.

Many current issues in market structure involve order-driven markets. Should oral auctions convert to automated auctions? Should crossing networks exist, and if so, should they be better integrated with the markets from which they derive their prices? Should markets organize more single price auctions and should they encourage traders to participate in them? How large should the minimum price increment be? In general, which market structure is best?

Each market structure has its advantages and disadvantages. This chapter identifies only some of the issues. To fairly compare market structures, you need to know more about why people trade, how they trade, and what brokers do. We will return to discussing the pros and cons of various market structures in the last part of the book.

• Limit order traders favor the uniform trade pricing rule.

• Large market order traders prefer the discriminatory trade pricing rule.

• Price priority is self-enforcing, but secondary precedence rules are not.

• Secondary precedence rules require a large minimum price increment to be economically significant.

• Single price auctions maximize trader surplus.

• Continuous auctions generate more volume for a given order flow.

• Markets that use the derivative trade pricing rule are subject to price manipulation.

CH 7 - Brokers

Brokers help their clients arrange trades. They match orders, they find traders willing to trade, and they clear and settle trades. Clients employ brokers for these tasks because brokers can do them more cheaply than they can themselves.

The principal-agent problem affects relations between brokers and their clients. Brokers may not always do what their clients pay them to do. Clients solve the problem by rewarding their brokers when they perform well and penalizing them when they do not.

Unfortunately, most brokerage clients cannot easily measure their brokers’ performance. Regulators consequently concern themselves with best execution standards. These standards define minimum service guarantees that clients can expect from their brokers. The standards are meaningful only if clients or market regulators can audit broker behavior.

The structures of all mechanisms which facilitate trade reflect the unfortunate fact that not all traders are honest and reliable. Traders have created elaborate clearing, settlement, margin, custodial, and audit procedures to ensure that all negotiated trades settle, all parties honor their financial commitments, traders do not violate rules, and nobody steals assets that belong to others. In addition, government, exchange, and industry association regulators oversee trading to protect the integrity of the markets.

• Brokers help arrange and settle trades for their clients.

• Brokers and exchanges compete with each other to arrange trades.

• Cash management is a significant source of profits for many brokers.

• The principal-agency problem can be a significant problem in the brokerage industry because quality of service is hard to measure.

• Soft commissions allow institutional funds to use trading commissions to finance their expenses and thereby report lower expense ratios.

• Many aspects of brokerage operations and of clearing and settlement mechanisms reduce the potential for fraud among traders.

CH 8 - Why people trade

Traders use markets for many reasons. Whether they are successful or not often depends on how well they understand the reasons why they trade.

Utilitarian traders trade because they expect to receive some benefit from trading besides profits. Investors and borrowers trade to move money through time. Asset exchangers trade one asset for another asset that has greater immediate use for them. Hedgers trade risks. Gamblers trade to obtain exciting entertainment. Fledglings trade to learn about trading. Cross-subsidizers trade to transfer wealth to others. Tax avoiders trade to take advantage of tax loopholes.

Profit-motivated traders trade only because they expect to profit from their trading. Profit-motivated traders include speculators and dealers. Speculators try to predict future price changes. Dealers sell liquidity to other traders. Speculators differ by the information they use to forecast future price changes. Informed traders use information about fundamental values, order anticipators use information about what other traders will do, and bluffers create information designed to convince other traders to trade foolishly.

Futile traders are unskilled, irrational, or poorly advised. These traders consistently lose, even though they expect to profit.

Utilitarian traders and futile traders lose on average to profit-motivated traders. Without them, profit-motivated traders could not profit. Profit-motivated traders therefore need to understand why utilitarian and futile traders trade if they are to profit from their trading.

Many people confuse investing, speculating, and gambling. Investors are uninformed traders who trade to move money from the present to the future. They expect to receive a fair rate of return for the risks that they bear. Speculators are traders who use information to predict future returns more accurately than most traders can. They trade because they expect to profit from trading. Gamblers are uninformed traders who trade for excitement. Though they often think that they are speculators, they are not able to predict price changes well enough to trade profitably in the long run. Investors typically trade only in securities markets. Speculators trade in all financial markets and all gambling markets in which they can predict future returns. Gamblers trade in any market that interests them.

All traders except dealers like to trade in liquid markets. Liquid markets allow traders to achieve their objectives at low cost. Since dealers sell liquidity, they prefer to trade in illiquid markets. Their services are more valuable in illiquid markets than in liquid markets. Their trading makes markets more liquid.

• Utilitarian traders trade because they expect to obtain some benefit from trading besides profits.

• Investors and borrowers move money through time.

• Hedgers exchange risks.

• Asset exchangers trade to obtain assets of greater value to them than the assets that they tender.

• Gamblers trade for entertainment.

• Profit-motivated traders trade only because they expect to obtain profits.

• Speculators trade on information about future price changes.

• Dealers profit from offering liquidity to other traders.

• Futile traders believe that they are profit-motivated traders, but they cannot trade successfully enough to profit in the long run.

• Pseudo-informed traders trade on stale information.

CH 9 - Good markets

Most people would like to have the best markets possible. To obtain such markets, sometimes regulators have to intervene to impose necessary changes, and sometimes we have to defend our markets against harmful regulatory interventions. In either event, we can best justify our policies in public discourse by showing that they maximize social welfare.

Although the determinants of social welfare are subjective, most people would agree that we should organize markets to maximize the benefits that accrue to the traders who use them and to the economy at large. Accordingly, this chapter has considered the private benefits that traders obtain from the markets and the public benefits that we all enjoy when markets work well.

Traders benefit from highly liquid markets in which they can accomplish their purposes at low cost. Most people agree that public policy should strive to create liquid markets.

The economy benefits greatly from markets that produce informative prices. Informative prices help us to efficiently organize economic activity. People rely upon prices when deciding how to allocate capital to new projects and when deciding how to allocate managers to existing projects. Economies become wealthy when these decisions are made well, and they suffer when they are made poorly. Most people agree that public policy should strive to create markets that produce informative prices.

Public policy becomes quite interesting when these simple objectives conflict with each other. For example, in chapter 29 we show that rules which restrict insider trading usually increase liquidity while making prices less informative. In such circumstances, we need a more thorough understanding of our objectives to decide which policies promote our welfare.

Since the objectives of public policy are subjective, people will disagree about policies. Such disagreements typically arise when a policy affects someone’s economic welfare. Although such conflicts are unavoidable, most people more willingly accept policies that hurt them if they are founded on deep principles which we all share. The ultimate challenge faced by honest public policy makers is to promote the public good against powerful and highly vocal private interests. The problem is most difficult when we poorly understand what constitutes the public good. I hope that this chapter has helped you to form well-reasoned opinions about what good markets are.

• Profit-motivated traders cannot profit on average if they trade only with each other.

• Markets ultimately exist only because utilitarian traders benefit from trading.

• Markets produce information used in production decisions and allocation decisions.

• Informative primary market prices help ensure that only the most promising projects receive new capital.

• Informative secondary market prices help allocate the best managers to existing capital.

• Many schemes that investors use to motivate their managers work best when secondary market prices are highly informative.

• The public benefits to the economy of well-functioning markets are largely responsible for the prosperity of market-based economies.

• Most people believe that markets work best when transaction costs are low and prices are informative.

CH 10 - Informed traders and market efficiency

Informed traders make prices informative. They acquire information that they hope will allow them to estimate values accurately. They buy when prices are lower than their value estimates and sell otherwise. Their buying and selling push prices up and down. They move prices closer to their estimates of value and thereby make prices more informative.

Four types of informed traders try to profit from information about fundamental values. Value traders estimate fundamental values by using all available information. News traders estimate changes in fundamental values from new information. Information-oriented technical traders identify patterns that are inconsistent with prices which reflect fundamental values. Arbitrageurs estimate differences in fundamental values across instruments.

Informed traders make markets efficient. In an efficient market, prices reflect all information that traders can acquire and profitably trade upon. How informative prices are depends on the costs of acquiring information, and on how much liquidity is available to informed traders. If information is expensive, or the market is not liquid, prices will not be very informative. Since trading is a zero-sum game, informed traders can profit only if uninformed traders lose to them. Prices therefore will not be informative in markets with few uninformed traders.

Informed traders compete with each other to profit from acquiring and acting upon information. Only those traders who can collect and analyze information at low cost, and who can trade effectively, are profitable.

No market is always completely efficient. Informed traders could not profit in such markets. Prices become more informative when informed traders push prices toward values. Prices become less informative when values change or when uninformed traders move prices. News traders tend to make money when values change. Value traders tend to make money when uninformed traders move prices.

Traders who intend to speculate should carefully consider why they expect to be successful. The most common mistake informed traders make is to trade when they have no comparative advantage.

• Informed traders make prices informative.

• Value traders estimate fundamental values.

• News traders estimate changes in fundamental values.

• Information-oriented technical traders estimate patterns that are inconsistent with fundamental values.

• Arbitrageurs estimate differences in fundamental values.

• Prices are most informative when the costs of obtaining information and the costs of trading are both low.

• When prices fully reflect all available information, nobody can forecast future price changes.

• Prices cannot always be completely informative.

• Trading is a zero-sum game when performance is measured relative to the market return.

• Informed traders profit only when other traders are willing to lose to them. Markets therefore require utilitarian traders in order to produce informative prices.

CH 11 - Order Anticipators

Order anticipators are speculators who attempt to profit from information about the trades that other traders will make rather than from information about fundamental values. They trade in front of other traders. They profit when other traders move prices to complete their trades.

Order anticipators are parasitic traders because they profit only by exploiting other traders. They generally do not make prices more informative, and they do not make the markets more liquid.

Order anticipators differ by what they know about the trades that other traders will make. Front runners know exactly what other traders have decided to do. Sentiment-oriented technical traders try to predict what other traders will decide to do. Squeezers force other traders into making trades at very disadvantageous prices.

Traders protect themselves from order anticipators in several ways. They protect themselves from front runners primarily by closely guarding information about the trades that they intend to do. They protect themselves from sentiment-oriented technical traders by trading quickly. They protect themselves from squeezers by always making sure that they have multiple ways to close their positions.

Markets can help protect traders from some types of order anticipators. Markets protect liquidity suppliers from quote matchers with order precedence systems that give time precedence to traders who expose their orders first. Such systems are meaningful only if they also have a significant minimum price increment that forces front runners to significantly improve prices if they want to trade first.

• Order anticipators profit when they can exploit information about other traders’ orders.

• Since they do not offer liquidity or make prices more informative, order anticipators are parasitic traders.

• Front runners front-run orders that other traders have submitted.

• Quote matchers front-run traders who offer liquidity.

• Sentiment-oriented technical traders anticipate the orders that other traders will submit.

• Squeezers anticipate trades that other traders must make.

• Traders who are aware of stop orders may manipulate them.

CH 12 Bluffers and Market Manipulation

Bluffers try to fool traders into offering liquidity unwisely. They fool traders by affecting the information that traders use to make their trading decisions. Rumormongers disseminate information about values. It may be false information or it may be true information that they distribute in a manner that they believe traders will misinterpret. Price manipulators trade at prices and in volumes that they hope will fool traders into thinking market conditions are different from what they truly are. In particular, they try to fool traders into believing that they are well-informed traders. Table 12-3 summarizes the techniques that bluffers use to fool other traders. Bluffers generally can profit when the price impact of their purchases is different from the price impact of their sales. When purchases have greater impact than sales, they buy first and sell later. When sales have greater impact than purchases, they sell first and buy later. Such bluffing strategies are not profitable, however, when transaction costs are high.

The traders most vulnerable to bluffers are momentum traders and liquidity suppliers. These traders trade in response to trades that they see. Since bluffers can affect the trades that these traders see, bluffers may fool them into making poor trading decisions. To avoid these losses, traders must be very careful about how they interpret trade prices, sizes, and times.

Value traders can call a bluffer’s bluff. If bluffers move prices away from fundamental values, value traders may identify profitable trading opportunities. Their trading makes it difficult for bluffers to control the market, and it diminishes the profits that bluffers make. Failed bluffs can be very expensive to bluffers.

• Bluffers profit by fooling traders into offering liquidity unwisely.

• Bluffers hope that other traders will mistakenly identify them as well-informed traders.

• Momentum traders must be especially careful to avoid trading with bluffers.

• When the price impacts of sales and purchases differ and transaction costs are not too large, bluffers can design profitable trading strategies.

• Bluffing destabilizes prices.

• Bluffers can lose when large value traders trade against their positions.

CH 13 - Dealers

Dealers sell immediacy—the ability to buy or sell quickly when you want to—to their clients. Dealers acquire their clients by offering attractive prices and good service, by advertising, and by paying brokers to direct their client orders to them. The bid/ask spread is the price of liquidity that they sell.

Dealers try to buy and then quickly sell, or to sell and then quickly buy. They do not like to accumulate large inventory positions. When they hold large inventories, they risk large losses should prices change against them.

Dealers set their bid and offer prices to obtain and maintain two-sided order flows. Two-sided order flows allow them to keep their inventories at their target levels. When inventories deviate from their target levels, dealers must adjust their bid and offer prices to encourage their clients to initiate trades that will restore their inventories, and to discourage their clients from initiating trades that would cause them to deviate further. Dealers sometimes demand liquidity from other traders when they are especially impatient to adjust their inventories.

Dealers lose to well-informed traders who can predict future price changes. When informed traders are trading, the order flows that dealers receive are not balanced, dealer inventory imbalances become inversely correlated with future price changes, and dealers thereby lose money. Dealers avoid these adverse selection losses by setting their bid and offer prices so that they surround their best estimates of fundamental values. They estimate values by using all information available to them. Dealers pay particularly close attention to their order flows because they partially reveal what informed traders believe about values. Successful dealers also try to avoid trading with informed traders if they can.

When setting their bid and ask prices, dealers anticipate what they will learn about values when they discover whether the next trader is a buyer or a seller. If a buyer arrives, values may be higher than dealers otherwise estimated. Dealers accordingly set their ask prices slightly higher than they otherwise would. Likewise, they set their bid prices slightly lower than otherwise to reflect what they will learn about values should a seller next arrive. These price adjustments constitute the adverse selection spread component.

Dealing is a complex activity in which dealers try to discover who is informed, who is bluffing, and who wants to trade for other reasons. Dealers must constantly make these judgments as they try to discover the market prices that will generate the balanced order flows that they need to easily control their inventories.

• Dealers quote prices to control their inventories and to obtain two-sided order flows.

• Dealers attract order flow by quoting aggressively and by offering order flow inducements.

• Informed trading hurts dealers.

• Dealers learn about values from their order flow and adjust their quotes accordingly.

• Dealers often discover fundamental values in their search for market values.

• The inferences dealers make about future order flows create a spread between their bid and ask prices. This spread is called the adverse selection spread component.

• The adverse selection spread component increases with trade size.

CH 14 - Bid/Ask Spreads

Bid/ask spreads depend on numerous factors. The most important are asymmetric information, volatility, and utilitarian trader interest.

Information is asymmetrically distributed among traders when some traders are better informed than others. Asymmetric information makes the order flow informative and causes dealers to lose money to better-informed traders. Dealers widen their spreads to recover from uninformed traders what they lose to informed traders. Dealers also widen their spreads to anticipate what they learn from the order flow when they discover whether the next trader is a buyer or a seller. These two explanations imply the same adverse selection spread component. It will be large when the order flow includes many informed traders and when the informed traders have highly material information.

Volatility affects bid/ask spreads by increasing the option values of standing limit orders and dealer quotes. When liquidity suppliers cannot adjust their prices quickly, they give timing options to market order traders. The value of this timing option increases with volatility. Dealers widen their spreads, and limit order traders back away from the market, to decrease the value of the timing option. Volatility also indirectly determines bid/ask spreads because it is a good proxy for asymmetric information.

Utilitarian trader interest ultimately determines market trading activity. Actively traded instruments have narrow spreads because dealers can spread their costs of doing business over more trades, because dealers can more effectively manage their inventory risks, and because the competition to supply liquidity is intense. Measures of market activity, such as trading volumes and trading, frequency therefore vary inversely with spreads. Factors that determine market activity, such as firm size, hedging suitability, and volatility, therefore also are inversely correlated with bid/ask spreads.

The equilibrium model shows that spreads in order-driven markets adjust to ensure that some traders will be indifferent between taking liquidity with market orders (and marketable limit orders) and offering liquidity with limit orders. Those who value their time highly and those who are most risk averse will take liquidity. Those who can adjust their order prices quickly may offer liquidity. On average, limit order strategies will execute at slightly better prices than market orders strategies because market order traders must compensate limit order traders for the additional management time, price risk, and timing options associated with limit order strategies.

Adverse selection helps us understand why uninformed traders lose whether they submit limit or market orders. If they use limit orders, they suffer adverse selection. When they compete with informed traders, their limit orders do not fill, and they subsequently wish they had traded. When they offer liquidity to informed traders, their limit orders quickly fill, and they subsequently wish that they had not traded. If they use market orders, they avoid direct adverse selection, but they still suffer its indirect effects because they must pay dealers the adverse selection spread. The adverse selection spread is effectively a fee dealers charge uninformed traders for bearing their adverse selection risk. Uninformed traders thus lose however they trade. If they want to avoid losing, they must avoid trading.

Asymmetric information is extremely important in trading. In this chapter, we used it to explain bid/ask spreads, why uninformed traders lose no matter how they trade, and why small firms cannot obtain public financing. In subsequent chapters, we will use the model to help us understand block trading, why governments regulate insider trading, and why stock index contracts are so liquid.

• Competition among dealers and from limit order traders keeps spreads small.

• Dealer spreads depend on their costs.

• Informed trading makes spreads wide.

• Uninformed traders indirectly lose to informed traders when they pay spreads made wide by adverse selection.

• Spreads are small in active markets for well-known assets.

• Large anonymous traders are widely thought to be well informed.

• Limit order traders give away timing options to traders who can respond to changing market conditions more quickly.

• When all traders are identical, limit order strategies produce better prices on average than market order strategies because traders value their time and do not like to risk failing to trade.

CH 15 - Block Traders

Block trades are trades that are too large to arrange easily using normal trading methods. They usually involve more size than is typically available at an exchange or in a dealer network.

Four problems make block trades costly to arrange:

• Block liquidity suppliers may be hard to find because most traders do not express their trading interests.

• Block initiators are reluctant to advertise their interests for fear of spoiling their markets.

• Block liquidity suppliers fear that block initiators will try to price discriminate among them by breaking up their orders.

• Block liquidity suppliers fear that block initiators may be well informed.

Block traders solve these problems by keeping track of who might be interested in trading, by selectively exposing block orders, by determining the full size of their clients’ orders, and by determining whether their clients are well informed. Since traders cannot easily undertake these activities on the floor of an exchange, traders arrange most large block trades off the exchange floors. Table 15-3 provides a summary of the skills that good block traders must have.

Block trading markets work well only when traders know each other well. Anonymous traders generally cannot credibly exchange the information that block traders require of each other. Since anonymous traders cannot establish reputations, they have no incentive to reveal information honestly. Trading systems that match anonymous buyers to anonymous sellers therefore cannot easily arrange block trades.

Block traders must be very careful when they agree to help a block initiator find liquidity. If they act as dealer and offer the liquidity themselves, they must be confident that prices will not move against them before they can divest the blocks that they facilitate. Otherwise, they will lose. If they act as broker and arrange to have other traders fill the order, they also must be confident that prices will not move against their clients whom they have encouraged to offer liquidity. Otherwise, these clients will be reluctant to participate in future trades that the block brokers may propose.

• Block trading markets primarily serve large uninformed traders.

• Order exposure is very important to large traders.

• Informed traders may pretend that they are uninformed to obtain liquidity more cheaply.

• Large traders may split their orders to price discriminate among liquidity suppliers.

• To trade successfully, block dealers and brokers must determine whether their clients are well informed and whether their clients want to price discriminate.

• Block dealers lose their capital when they do not know their clients well.

• Block brokers lose their reputations when they do not know their clients well.

• Delayed trade reporting favors informed over uninformed traders, and block dealers over block brokers.

CH 16 - Value traders

Value traders supply liquidity to uninformed traders whose trading pushes prices away from fundamental values. Value traders are liquidity suppliers of last resort. When no one else will trade—when dealers have large positions or when liquidity suppliers fear informed traders—value traders may trade. Since they allow uninformed traders to trade large positions, they supply depth to the market. Since they often recognize when uninformed traders have caused prices to move from fundamental values, they also make markets resilient.

Value traders can afford to take large positions only by being the best-informed traders in the market. They risk being wrong, however. They suffer adverse selection when they lose to news traders who know news that they do not yet know, and they face the winner’s curse when they under-or overestimate values. They widen their spreads to avoid these risks and to ensure that they recover from uninformed traders what they occasionally lose to news traders and to other value traders.

By making markets resilient, value traders allow dealers to offer more immediacy to uninformed traders than they otherwise would be willing to offer. Dealers know that they often will be able to lay off their inventories when value traders closely follow the market. Accordingly, they are more willing to take large positions because they know that they may not have to hold them long.

• Value traders are the ultimate suppliers of liquidity to uninformed traders.

• The winner’s curse hurts traders who make the highest bids or the lowest offers if they do not anticipate what they will learn about the values that other traders estimate.

• The outside spread represents the prices at which value traders will buy and sell.

• The outside spread is wider than the inside spread.

CH 17 - Arbitrageurs

Arbitrageurs play many roles in the markets. They enforce the law of one price, they discipline slow traders, they connect buyers to sellers, and they repackage risks into forms that other traders find most useful. These activities provide benefits to the economy and to individual traders.

Arbitrage trading strategies are special cases of more basic trading strategies. Arbitrageurs are simply traders who deal or speculate in their hedge portfolios. Trading two or more instruments simultaneously can be difficult, however, especially when price volatility is large relative to the basis. Good arbitrageurs therefore tend to be good traders.

Arbitrage is not easy. To trade successfully, arbitrageurs must properly understand the arbitrage relation, they must successfully implement their positions, and they must control their carrying costs. Arbitrageurs risk losing when the basis moves against them, when carrying costs are unexpectedly large, when they falsely identify arbitrage opportunities, and when they can no longer carry their positions because they have grown too large. Successful arbitrageurs must anticipate these problems and deal with them as they arise.

Arbitrageurs profit from mean reversion in the basis. In pure arbitrages, the basis must revert. Arbitrageurs can still lose, however, if the reversion takes too long. In speculative arbitrages, the nonstationary component of the basis may dominate the mean-reverting component, and the basis may never revert.

The most successful arbitrageurs understand why their arbitrage opportunities arise. They then know how best to trade, and they are less likely to trade when they should not trade.

Since arbitrageurs trade in more than one market, we need to consider their behavior when we consider how markets relate to each other. We discuss how arbitrageurs transmit volatility between markets in chapter 20, and in chapter 26 we show that arbitrageurs are instrumental in keeping fragmented markets together.

• Arbitrageurs trade similar risks in related markets.

• Arbitrageurs generally are dealers or value traders in their arbitrage hedge portfolios.

• Arbitrageurs convert assets and risks to different types, forms, or locations.

• Arbitrageurs are cross-sectional dealers.

• A large basis tells arbitrageurs to move liquidity from one market to another or to convert risk from one form to the other.

• The basis pays for the arbitrageurs’ services.

• Arbitrage enforces the law of one price across fragmented markets.

• Successful arbitrageurs are low cost traders.

CH 18 - Buy-Side Traders

Buy-side traders must pay close attention to their order submission strategies in order to trade effectively. The strategies that they choose depend on the problems that they solve. Traders who are impatient to trade generally use market orders, while those who are patient or who do not need to complete their trades use limit orders.

All traders pay close attention to the price of liquidity. When spreads are wider than normal, limit orders may be more attractive than market orders. When spreads are narrower than normal, market orders may be more attractive.

Trades are easiest to arrange when traders broadly expose their orders. Unfortunately, exposure can reveal trader motives, the potential price impacts of future trades, and valuable trading options. Traders can exploit this information to their advantage and to the detriment of exposing traders.

Exposure decisions are the most important decisions that large traders make. Good traders know when and to whom to expose their interests. Poor traders expose to the wrong traders, they expose at the wrong times, or they fail to expose when they should.

Traders concerned about exposing their interests employ a variety of techniques to control their exposure. They use brokers to represent them anonymously, they split their orders, they use market orders instead of limit orders, and they selectively expose to those traders who are most likely to trade with them and least likely to front-run them.

Markets can help traders who are concerned about order exposure by adopting rules that protect them. Time precedence, in conjunction with an economically significant minimum price increment, helps protect exposed orders by making front-running strategies less profitable. Since regulators and exchanges can specify the size of the minimum price increment, they can control the degree to which traders expose their orders. Moreover, since traders clearly appear to be reluctant to display their large orders, exchanges that do not presently offer facilities to represent undisclosed orders may be able to obtain more order flow by offering these facilities. Without these facilities, traders tend to split their large orders into pieces.

• Buy-side traders must choose the best order submission strategies for the trading problems that they solve.

• The choice between limit order strategies and market order strategies depends on the price of liquidity, the size and price placement of standing limit orders in the trading system, and the consequences of failing to trade.

• In general, traders should offer liquidity when it is expensive and buy it when it is cheap. Experienced traders know when liquidity is expensive or cheap.

• Order exposure decisions are the most important decisions large traders make.

• Traders expose to encourage other traders to trade with them.

• Traders avoid exposing when they fear that other traders will front-run their orders or avoid trading with them.

• The art of trading large orders lies in knowing when and how to expose trading interest.

CH 19 - Liquidity

Liquidity is often discussed but rarely well understood. The confusion has its origins in the complexity of the bilateral search problem, in which buyers search for sellers and sellers search for buyers.

Liquidity is the object of this bilateral search. It is the ability to trade large size quickly at low transaction cost. This simple definition reflects the complexity of the concept. Liquidity has size, time, and cost dimensions. Traders generally refer to these respective dimensions as depth, immediacy, and width.

Impatient small traders easily solve the bilateral search problem because they typically trade at exchanges and in dealer networks that assemble information about who wants to trade and the prices at which they will trade. These trading systems act as search engines. To increase the probability that liquidity-demanding traders will trade with them, most liquidity suppliers in these systems provide firm quotes and orders. Small liquidity-demanding traders therefore need to search only for the best price. Order-driven trading systems that use price priority rules in their matching systems provide this service automatically.

Patient small traders offer limit orders, hoping that someone will find them. This trading strategy is more complex than simple market order strategies because their orders may not fill. When they do fill, however, they typically get better prices than do market order traders.

For large traders, the bilateral search problem is more complex. Many large traders are reluctant to expose their orders. Markets for large size therefore are not very transparent. Search costs can be high, and search strategies may greatly affect the ultimate execution prices.

Five types of traders offer liquidity. Market makers offer immediacy at narrow spreads to small anonymous traders. Block dealers offer depth to large uninformed traders. Value traders offer depth to all traders. Precommitted traders offer immediacy at very narrow spreads in an effort to lower the costs of trades that they already intend to do. Arbitrageurs move liquidity from one market to another market and thereby ensure that traders can find depth wherever they trade.

• Liquidity is the object of a bilateral search problem.

• Liquidity is the ability to trade when you want to trade, at low cost.

• Brokers and exchanges organize liquidity that traders offer.

• Liquidity has several related dimensions.

• Market makers primarily supply immediacy.

• Upstairs traders primarily supply depth.

• Value traders make markets resilient.

CH 20 - Volatility

Traders pay close attention to volatility because price changes affect their profits and losses. Periods of high volatility are highly risky to traders. Such periods, however, also can present them with opportunities for great profits.

Regulators pay close attention to volatility because one form of volatility—transitory volatility—is correlated with transaction costs. Regulators generally try to create liquid markets that produce highly informative prices. High volatility suggests to them—and to many others—that markets need to be fixed

• Fundamental volatility is due to unexpected changes in fundamental valuation factors.

• Fundamental price changes are correlated with volume when only a few traders know new information about fundamental values. When such information is common knowledge, prices can change on little or no volume.

• Fundamental volatility may be scary, but it is necessary for the efficient allocation of resources.

• Prices must change as the world changes if they are to reflect all current information about instrument values.

• Transitory volatility consists of price changes caused when impatient uninformed traders seek liquidity.

• Transitory volatility and transaction costs are closely related. Both are high in illiquid markets.

• The price changes associated with transitory volatility tend to revert. Price reversion causes negative correlation in a price change series.

• Transitory volatility is identified by the negative serial correlation due to price reversals.

CH 21 - Liquidity and transaction cost measurement

Traders estimate their transaction costs so that they can better manage their trading. Good information about their transaction costs allow them to do the following:

• Determine whether they obtain good value for the commissions they pay their brokers

• Balance their transaction costs and their missed trade opportunity costs to optimize their order submission strategies

• Ensure that their trading strategies are—and will be—profitable when implemented

Although transaction cost measurement is noisy, it can produce valuable information that traders can use to help solve these problems.

For many investment managers, reducing transaction costs through more effective trade implementation management improves performance more than would devoting the same resources to improving their portfolio selection decisions. Decreasing transaction costs is often easier and more reliable than improving portfolio section decisions.

• Total performance depends on portfolio selection and trade implementation.

• Transaction costs lower portfolio performance.

• Traders estimate transaction costs so that they can better manage them.

• Missed trade opportunity costs can be more significant than transaction costs. Good traders find a balance between the two types of costs when they decide how aggressively to trade.

• Transaction cost measurement depends on price benchmarks.

• Reliable inferences about transaction costs require reasonable benchmarks and many trades.

• Informed trading, contrarian trading, order splitting, and gaming may bias some transaction cost estimates.

• Brokers often can game a transaction cost measure by deferring trades or by mimicking their benchmarks.

• Transaction costs to the buy side are revenues to the sell side.

• Good managers consider transaction costs when making portfolio composition decisions.

CH 22 - Performance evaluation and prediction

People primarily examine past performance because they want to predict good future performance. Unfortunately, good past performance does not necessarily predict good future returns. In fact, it rarely does. Over human time frames, luck is generally a more important determinant of good performance than is skill. In addition, the skills that may have been responsible for good past performance may not produce good future performance. Moreover, a formerly skilled manager may not still be skilled. These issues make the prediction of good future performance from good past performance an essentially worthless activity.

The contribution is small because many traders compete with each other to profit. Their trading makes prices quite informative, so that most price changes are not predictable. Statistical performance evaluation therefore is unreliable without more data than are generally available to us.

The importance of luck cannot be overemphasized. It is much better to be lucky than skilled. The luckiest managers in a large group of managers will certainly perform better than almost all skilled managers with average luck. Superior past performance—even that of the most acclaimed managers—by itself does not necessarily indicate skill.

These results do not imply that there are no skilled managers. The discussions in chapters 10-12 about speculative trading strategies suggest that skilled managers exist and are profitable. Some skilled managers may even be able to beat the market by more than the average 2 percent that we have assumed throughout this chapter. Unfortunately, we probably cannot identify these managers only from past returns.

To identify skilled managers, it is best to consider the characteristic factors that generate superior performance. These factors include intelligence, experience, education, training, creativity, memory, discipline, drive, and access to data. Managers who have these characteristics tend to perform better than those who do not.

Most professional managers have these characteristics and therefore appear to be good managers. They probably can manage better than most people. However, they mostly compete with other managers, not with the average person. Winning managers are those who have a comparative advantage. They are not just good managers, they are better managers. To identify a successful manager, you must therefore be familiar with many managers so that you can compare them. If you do not have the characteristics of a successful manager, you probably will not trade successfully in the long run.

Perhaps the most important indicator of a skilled manager is whether the manager clearly understands that success comes from having a comparative advantage. Managers who are not constantly thinking about their comparative advantages cannot know when they should trade. I would be very reluctant to invest with managers who confuse absolute advantage with comparative advantage. Successful managers should be able to clearly articulate the comparative advantages that they believe will allow them to profit in the zero-sum game.

• Distinguishing skill from luck is very difficult.

• The skills that produced superior performance in the past may not produce such performance in the future.

• Past returns do not necessarily indicate future returns.

• Even when they have no skill, many traders will perform very well just by chance.

• Sample selection biases seriously affect common inferences.

• To avoid the sample selection problem, we must always consider how information came to our attention.

• An analysis of comparative advantage is probably the only reliable way to determine who can trade well.

CH 23 - Index and Portfolio markets

Interest in index markets has increased substantially since the early 1970s as investors have better understood the implications of the zero-sum game. On average, active managers cannot outperform the market. Transaction costs and high management fees ensure that they underperform the market on average. Investors who do not want to actively speculate—either by themselves or by choosing investment managers—find that index funds are quite attractive.

The removal of index order flow from underlying security markets to index product markets has greatly decreased the costs of pursuing index strategies. Index markets are quite liquid because they concentrate order flow and because few traders are well informed about broad-based index values. Index products are much cheaper to trade than the component instruments.

Low transaction costs in index markets have made these markets very attractive to speculators. They use them to speculate in index risk or to hedge out the index risk associated with their speculative positions in individual securities.

• Indexes characterize the average price performance of a set of index stocks.

• Index funds hold portfolios designed to replicate the returns of a price index.

• Index funds have very low turnover rates because managers rarely need to rebalance index portfolios.

• Investors hold index products to avoid transaction costs and to eliminate losses often associated with active management.

• Index markets provide low-cost ways to trade index risk.

• Index dealers are generally unconcerned about security-specific risks.

CH 24 - Specialists

Exchanges and third market dealers designate specialists who must supply liquidity when no liquidity would otherwise be available. Traders like continuous, liquid markets. Exchanges and dealers hope to attract customers by offering such markets.

Specialists do not willingly take these obligations upon themselves without compensation. The compensation that specialists obtain is access to order flows which allow them to earn dealing profits and brokerage commissions. Information in the order flows also allows them to speculate successfully on short-term price changes.

The profits that specialists make are transaction costs for other traders. Specialist trading is most costly to limit order traders with whom they compete to offer liquidity. Specialists harm them by selectively stepping in front of their limit orders when specialists believe the resulting trades will be profitable.

Specialists consider many factors when deciding whether to trade. They prefer to trade with small uninformed traders. They like to trade in front of the heavy side of the limit order book in order to extract order option values. If exchanges allow specialists to stop market orders, they do so to create valuable look-back timing options.

In markets that enforce public order and time precedence rules, the profitability of specialist trading strategies depends on the minimum price increment. When the increment is small, the cost to specialists of stepping in front of other traders is small.

Although traders value the liquidity that specialists offer, they do not like to pay for it if they can avoid it. Since the specialist system transfers wealth from limit order traders to market order traders, not all traders appreciate it. Regulators must therefore decide whether the liquidity supplied by specialists to some traders is worth the costs of the system to other traders.

Many traders and commentators believe that the regulatory problems associated with the specialist trading system are intractable. They believe that the special privileges which specialists enjoy allow them to take too much value from the markets, and that regulators can never adequately compel specialists to return commensurate value to the markets. These people lobby to replace the specialist trading system with a multiple designated market maker system or with a pure price-time priority screen-based trading system.

• Specialists are dual traders.

• The specialists’ affirmative obligations require that they provide liquidity when no one else will.

• The specialists’ negative obligations require that they refrain from providing liquidity in competition with the public.

• Specialists accept their obligations in exchange for some special privileges.

• Regulators and exchanges must balance the value of the special privileges with the value of the services that specialists provide.

• Price continuity can be expensive to provide.

• Price continuity is a public good that competitive markets generally will not provide.

CH 25 - Internalization , preferencing and crossing

Brokers internalize and preference order flows in order to extract value from largely uninformed orders that execute at wide spreads. Payments for order flow ensure that dealers in perfectly competitive wholesale dealing markets do not obtain excess profits from trading these orders at wide spreads. The commissions and other order flow inducements which brokers must offer their clients to obtain their orders ensure that brokers in perfectly competitive retail brokering markets do not profit excessively from internalization or payments for order flow. When competition is perfect in retail and wholesale order flow markets, low commissions offset poor execution so that net prices do not ultimately depend on best execution standards.

In no market is competition perfect, however. Dealers and brokers with market power will exploit that power and ultimately obtain excess profits from public traders. How much excess profit they obtain depends on how competitive these markets are.

Wholesale dealers have some market power by virtue of the economies of scale associated with their operations. These economies have led to substantial consolidations through mergers and acquisitions in the dealing segment of the trading industry. Although the remaining firms undoubtedly increased their market power, the economies of scale have also made them more efficient. These economies of scale make it difficult for new entrants to compete aggressively in the wholesale order flow market.

Generally, the more convoluted a competitive system is, the less efficient it will be. The wholesale and retail order flow market system is a more complex competitive system than a centralized market. We therefore can presume that it will be less efficient.

By taking orders away from common market mechanisms, internalization, preferencing, and internal order crossing practices make it harder for natural buyers and sellers to find each other. Internalization and preferencing also weaken central markets by reducing incentives to quote aggressively. These practices therefore must ultimately increase the total transaction costs of all buy-side traders. Internalization and preferencing, however, probably provide small uninformed traders with better net prices—spread plus commission—than they would otherwise obtain. Internal order crossing likewise provides many traders with services that exchanges and brokers would not otherwise provide. Regulators who would restrict internalization, order preferencing, or internal order crossing must consider the trade-offs between the benefits and costs of these practices.

Many people believe that the benefits some traders obtain from internalization, preferencing, and order crossing practices do not justify the damage these practices do to central markets. They would instead prefer a consolidated limit order book market structure that would bring all traders together in the same place. In chapter 26, we further consider the economic forces that consolidate and fragment markets.

• Competition among dealers and brokers ensures that payments for order flow reduce commissions.

• Retail customers can easily audit commissions but cannot easily audit trade executions.

• Internalization and preferencing decrease incentives to quote aggressively.

• Internalization and preferencing probably provide better net prices (spread plus commission) to small uninformed traders.

• Internalization and preferencing shift power from public limit order traders to dealers.

• Brokers like internal order crosses because they often can collect commissions from both sides of the trade.

CH 26 - Competition within and among markets

Markets consolidate because traders attract traders. Trading is easiest and cheapest where most traders of an instrument or similar instruments trade. Liquidity attracts liquidity.

Markets fragment because the trading problems that traders solve, differ. Different market structures serve some traders better than others. Markets fragment when, for enough traders, benefits from differentiation exceed benefits from consolidation.

Some traders are small and unconcerned about the price impacts of their trades, while other traders are large and very concerned about front running. Small traders prefer market structures that widely expose their orders so that everyone can see and react to them. Large traders prefer market structures that allow them to control how and to whom their orders are exposed.

Some traders are well informed about fundamental values and therefore very concerned about revealing their information, while others are relatively uninformed and very concerned about minimizing transaction costs. Uninformed traders prefer markets where they can be identified and given better prices. Informed traders prefer consolidated markets with anonymous trading so that they can hide in the order flow.

Some traders are impatient to trade and therefore willing to pay for liquidity, while others are patient and willing to wait for their price. The former prefer quote-driven markets, while the latter prefer order-driven markets. Not withstanding these differences, all traders appreciate the benefits of consolidation. Traders often trade in markets that they do not like simply because those markets are most liquid. Conversely, no market will attract and keep liquidity if it does not provide good service to many traders. Competition among market structures generally reveals the market structures that best serve various types of traders.

Fragmented markets consolidate when traders can access information about market conditions within each segment. Traders use this information to adjust their orders, reroute their orders, or issue new orders. Prices and liquidity in each segment thereby reflect information from all other segments.

Traders naturally enforce price priority in segmented markets when they seek the best prices for their orders. Traders do not enforce secondary order precedence rules, such as time precedence, across market segments. Only coordinated regulation can implement such rules.

Fragmented markets generally will provide less regulatory oversight than is socially optimal. Good regulatory activities benefit everyone, but exchanges can charge only those traders who trade in their segments. Only coordinated regulation can ensure that markets provide adequate regulatory oversight.

Two types of competition characterize segmented markets. Traders compete for the best price, and market centers compete to serve diverse traders. Unfortunately, policies that promote the benefits from one competition can decrease the benefits from the other. Regulators therefore must balance the benefits obtained from these two types of competition.

• Markets consolidate because traders attract traders. Liquidity attracts liquidity.

• Consolidation maximizes competition among traders and thereby most efficiently reveals the best price.

• A better market structure may never emerge if it cannot attract enough traders to move away from an incumbent market to make it liquid.

• The order flow externality is strongest when search costs are highest.

• When a market displays enough information about orders and quotes to accurately predict the average execution price of a market order, preferencing to dealers of such market orders can weaken the order flow externality held by that market.

• Markets fragment as exchanges, brokers, ECNs, and dealers compete to meet the diverse service requirements of different traders.

• Fragmented markets consolidate when traders can observe and act upon information in all market segments.

• Arbitrageurs help consolidate fragmented markets.

• Externality problems affect the competition among market centers to provide exchange services. Unregulated competition therefore may not create the best market structures.

CH 27 - Floor versus automated trading systems

Floor-based trading systems and automated trading systems have different strengths and weaknesses. Consequently, they appeal to different clienteles. It is unlikely that one market structure will dominate all trading. summarizes strengths and weaknesses of floor-based and automated trading systems.

Fully automated systems are very fast and generally cheap to use and operate. These characteristics ensure that active markets and markets that serve small traders will use automated trading systems extensively. In the U.S. equities markets, Bernard L. Madoff Investment Securities, Knight Capital Markets, and other dealers who offer automated execution systems provide excellent service to high volumes of small traders. Options markets tend to have high order volumes and small transaction sizes. We can expect that these markets will increasingly automate their trading. Fully automated systems also allow traders to exercise direct control over their orders. They therefore appeal to traders who do not trust their brokers or who do not want to pay for brokerage services. Large institutions that are concerned about how brokers expose their orders often favor automated systems if they are willing to employ their own buy-side traders.

Floor systems work best when traders need to exchange information about each other before they trade. They also work best when brokers need to actively search for traders to fill their orders. Since these advantages are most important to large traders, floor-based markets will serve primarily large institutional traders. The NYSE increasingly is an institutional market. Although people have been predicting the demise of the NYSE floor since the mid-1960s, it will not disappear as long as the NYSE floor traders continue to provide valuable services to traders that other systems cannot provide.

The communications and computational technologies that have enabled automated electronic markets allow these markets to exploit huge economies of scale. Consequently, many exchanges have merged to take advantage of scale economies. Many more will probably merge in the future.

In chapter 26, we noted that the order flow externality can make an incumbent market highly liquid even if it employs an inefficient trading technology. The continued existence of large floor-based markets therefore does not necessarily imply that their trading systems are better than fully automated trading systems.

• Electronic trading systems provide much better audit trails than floor-based trading systems.

• Electronic trading systems provide faster access to markets than floor-based trading systems.

• Floor-based trading systems are not as scalable as electronic trading systems.

• Floor-based trading systems allow brokers to exchange information that they cannot easily exchange in electronic trading systems. This information often is essential for arranging good trades for large traders.

• The order flow externality makes it impossible to conclude that large floor-based trading systems survive because their floor-based trading technologies are superior to electronic trading technologies.

CH 28 - Bubbles crashes and circuit breakers

Market crashes are like automobile and airplane crashes. In both cases, crashes usually do not occur for a single simple reason. Instead, a number of factors cause people to become confused about what is happening. Their confusion becomes most dangerous when they are uncertain about risk. They then pay attention to the wrong issues, they ignore important risks, and, if things happen too quickly, they panic and lose their ability to make good decisions. In all types of crashes, the survivors rarely make the same mistakes again. When crashes reoccur, it is often because new participants have failed to learn lessons learned by others.

The examples in this section show that most major market crashes are not short-term transitory trading problems. More often, the conditions that led to the crash started creating a bubble long before the crash occurred. Crashes more often represent a final restoration of rational pricing rather than a transitory problem in need of correction.

Regardless of these observations, political passion for change is often quite high following some crashes. Many people demand that regulators do something to prevent future occurrences. We next consider public policy responses to extreme volatility.

Extreme volatility is quite scary. Large price changes can quickly create, destroy, or transfer enormous wealth. Although people do not like extreme price changes, they can better accept them when they are due to fundamental valuation factors than when they are due to human folly. Rarely, however, is news about fundamental values so important and so surprising that it can explain dramatic price changes. Large price changes therefore often are the result of mistakes that people make. People pay close attention to these events because they do not want to repeat their mistakes.

Perhaps the most common mistake that traders make is to overvalue assets. They make this mistake when they are overly optimistic about future prospects, or when they do not fully appreciate risks. If enough traders share their enthusiasm, they push asset prices beyond fundamental values. Although well-informed value traders may recognize the problem, they may be unwilling or unable to trade in sufficient quantities to prevent a bubble from forming. The bubble pops when traders lose confidence.

Most regulatory initiatives associated with extreme volatility come too late. They also tend to address problems that have more to do with crashes than with the formation of the bubbles that ultimately lead to crashes. Trading halts and price limits, for example, at best only ensure that extreme price changes occur in an orderly fashion. They mainly attenuate volatility only to the extent that they prevent traders from overreacting.

The best way to prevent the formation of bubbles is to empower value traders who can recognize and trade against bubbles. Value traders are most willing to trade when they are confident that they understand values well. Regulators therefore should direct their policies toward lowering the costs of obtaining high quality information that value traders need to form reliable opinions about fundamental values.

Regulators also should try to remove any impediments to short selling that value traders may face. In particular, U.S. regulators should consider eliminating the short-sale rule that requires short sellers to sell stock on an uptick. They also should consider policies that would make it easier for short sellers to obtain short interest on the proceeds of their sales.

• The most common mistake traders make is to identify a good company as a good investment.

• Momentum traders are especially susceptible to losing in bubbles and crashes.

• Traders should not speculate if they cannot value the instruments that they trade.

• The portfolio insurance trading strategy is destabilizing when many traders use it, and when traders are uncertain about the total funds under portfolio insurance management.

• Portfolio insurance does not reduce fundamental equity risk. It merely attempts to transfer risk among traders.

• Trade halts and price limits protect liquidity suppliers when prices change quickly. These rules change the trade pricing rule from discriminatory pricing to uniform pricing.

• Traders can panic when they are uncertain about risk, and when unusual situations confront them with new trading problems that require quick solutions.

• Trade halts and price limits can stop a panic by giving traders time to obtain and analyze more information.

• Price limits can protect the clearing system by increasing the margin payments that bankrupt traders pay before they default.

• The gravitational effect associated with trade halts and price limits can increase volatility if traders fear that they will not be able to complete their trades before trading stops.

• After a crisis, regulators often adopt regulations that have little economic value simply to respond to public demands for action.

CH 29 - Insider trading

Regulators try to restrict insider trading in order to remove a class of informed traders from the market place. The assumed purpose of these laws is to make trading more fair, to protect liquidity suppliers from informed traders so that they can supply more liquidity to uninformed traders, and to control corporate managers. These laws narrow bid/ask spreads and make prices less informative in the short run.

The debate on insider trading is quite complex. Although some good arguments suggest that insider-trading laws are not necessary or desirable, these laws are quite popular. Little chance of an early repeal exists. Of greater concern is how much money regulators should spend to enforce insider-trading laws.

• Profitable insider trading hurts dealers and uninformed traders.

• Insider trading is hard to detect. Trading on inside information that firms will not soon reveal is especially difficult to detect.

• Insider trading is most profitable when insiders do not compete with each other to profit from their information.

• Profitable insider trading is associated with lower salaries for corporate insiders.

• Insider trading may encourage entrepreneurship among corporate managers.

End