Traders have many different ways of exposing their intentions. At opposite extremes, there are:
- Traders who actively publicize their interest in ways that will be fully credible to the other side. Traders may do this by submitting locked-in limit orders to systems that widely disseminate their interests.
- On the other extreme, traders can reveal their interests only to a broker (or an exchange) and then only when the broker can arrange a trade with someone else who has displayed a good order. Only the broker will know who initiated the trade. The other side will learn of the trader’s interest only after the broker arranges the trade. In some brokered markets, the broker may even be a computer.
A multitude of exposure levels and strategies lies between these two extremes.
Trading is the result of a successful bilateral search in which buyers look for sellers and sellers look for buyers. When the buyers and sellers are easy to find, they (or their brokers) can easily arrange their trades. This simple observation helps explain why trading tends to consolidate into a single central market. Traders who display their interests make it easy for other traders to find them.
Exposing trading intentions can definitely have some significant negative consequences. These costs are due to the actions that other traders may take in response to the exposed information as can be witnessed in the types of traders listed below.
Market manipulators, using false or misleading appearances, make a deliberate attempt to interfere with the free and fair operation of the market, and attempt to or act to create an artificial change with respect to the price of a security or a market movement with the intent to make a profit.
Examples of this type of activity are:
- Wash sellers - Traders who sell then quickly re-buy the same security, hoping to create the impression of increased trading volume, and therefore raise the price.
- Churners - Traders who make both buy and sell orders through different brokers to create the impression of increased interest in the security and raise the price.
- Poolers - In which agreements, often written, are made among a group of traders to delegate authority to a single manager to trade in a specific stock for a specific period of time and then to share in the resulting profits or losses.
- Stock bashers - Bashers make up false and/or misleading information about the target company in an attempt to get shares for a cheaper price. This activity, in most cases, is conducted by posting libelous posts on multiple public forums.
- Rampers (of the market) - Traders’ actions are designed to raise artificially the market price of listed securities and to give the impression of voluminous trading, in order to make a quick profit.
- Pumpers and dumpers - This scheme is generally part of a more complex grand plan of market manipulation on the targeted security. The perpetrators (usually stock promoters) convince company affiliates and large position non-affiliates to release shares into a free trading status as "Payment" for services for promoting the security. Instead of putting out legitimate information about a company, the promoter sends out bogus e-mails (the "Pump") to millions of unsophisticated investors (Sometimes called "Retail Investors") in an attempt to drive the price of the stock and volume to higher points. After they accomplish both, the promoter sells their shares (the "Dump") and the stock price falls like a stone, taking all the duped investors’ money with it.
- Bear raiders - Traders attempting to push the price of a stock down by heavy selling or short selling.
- Runners - Traders who create activity or rumors (painting the tape) in order to drive the price of a security up. An example is the Guinness share-trading fraud of the 1980s.
Manipulation can be used to both increase and decrease prices, depending on the investor's perceived needs. Manipulation is illegal under the Securities Exchange Act of 1934.
Parasitic traders profit only by exploiting other traders. They use exposed information to create trading strategies that profit at the expense of the exposing traders. They generally do not add value to the market. In particular, parasitic traders neither provide liquidity nor make prices more efficient. Since parasitic traders take from the markets without giving, they tend to degrade markets.
"Parasitic traders use exposed information to profit at the expense of vulnerable traders."
- Lawrence Harris, Professor of Finance at USC and former Chief Economist at the Securities and Exchange Commission
An example of parasitic activity is when large traders display their interests by revealing three types of information useful to other traders - why they want to trade, the potential price impacts of their future trades, and their valuable trading options. Parasitic traders may front-run the larger orders or they may try to extract value from the trading options that large traders offer, which can impose costs upon the exposing trader.
Defensive traders use exposed information to protect themselves from traders that would otherwise harm them. Their response to exposed information is to refrain from trading. They often make markets more price-efficient when they refrain from trading.
Using the same example above, a defensive trader may refuse to offer good terms to the large traders, which again will impose costs upon the exposing trader.
Squeezers hope to profit from controlling one side of the market so that anyone who has to liquidate a position on the other side must come to them. They can also be classed as parasitic traders because they design trading strategies that generate profit only when they can exploit other traders. Squeezers generally acquire their power by surreptitiously cornering the market before traders on the other side realize that they have lost the option to negotiate with others. Squeezers are unwilling to reveal their plans before they set their traps. Otherwise their prey will escape.
This type of stock trader simultaneously buys undervalued and sells overvalued instruments.
Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcy.
There are several risks associated with arbitrage traders, such as:
- Execution risk - Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. Competition in the marketplace can also create risks during arbitrage transactions. As an example, if traders were trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.
- Mismatch - Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a convergence trade. In the extreme case this is merger arbitrage, which can produce disastrous losses.
- Counterparty risk - As arbitrages generally involve future movements of cash, they are subject to counterparty risk if a counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.
- Liquidity risk - Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and be forced to sell these assets at a loss even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option on their ability to finance themselves.
These traders circle like eagles waiting for the weak and wounded to fall, and then they pick up the pieces. Many companies owe their survival in hard times to the bargain hunter. Kmart is one company that pulled through and recovered after Wall Street left it for dead.
At first glance this trader may not seem to have a viable place in the market, but looks can be deceiving. This trader wants to roll their money over and trade stocks constantly - that is part of the game. They are only interested in research and learning as long as there is money to play with.
Bluffers are generally unwilling to reveal their intentions. Bluffers attempt to fool other traders into trading unwisely. For example, they may buy quietly to acquire a substantial position. They then buy aggressively to convince people that informed traders are competing to profit from some piece of news. They then sell to momentum traders who foolishly try to profit from the “news” that they have inferred. The strategy works when traders are easily fooled. It fails when value-motivated traders recognize that the bluffer has pushed prices away from their fundamental values. Bluffers do not want to reveal their trading intentions because they do not want value-motivated traders to call their bluffs. Since bluffers profit only when they exploit other traders, bluffers are also classed as parasitic traders.
Bluffers also want to expose their trading after they have acquired their positions. To trade out of their positions profitably, they must encourage momentum traders to follow them. They do this by convincing other traders that they are well informed. Since well-informed traders often trade aggressively, bluffers try to fool other traders by trading aggressively. At this point in their strategy, bluffers want other traders to notice their trading. They are then willing to expose their orders, but certainly not their strategy.
A rogue trader is an authorized employee making unauthorized trades on behalf of their employer. It is most often applicable to financial trading, where professional traders make unapproved financial transactions.
Men like Kweku Adoboli and Jerome Kerviel, and other rogue traders like Nick Leeson of Barings Bank (who lost $1.3 billion) or John Rusnak of Allied Irish Bank (who lost $691 million), do not intentionally set out to blow things up.
Instead, the trouble usually starts small - an attempt to cover up a modest portfolio loss, or to make a poor reporting period look better.
The goal is to make a little extra money quickly - enough to cover the small problem - and then go back to normal, with no one the wiser.
If the double-down scheme works, the traders’ names never shows up in the news. They may even earn a nice bonus at the end of the quarter.
But if it doesn't work, and the initial loss snowballs, that's when the real trouble begins. As problematic losses become too big to manage, desperation kicks in. Bigger and bigger bets are made, until finally it all unravels.
This activity is in the grey area between civil and criminal illegality for the reason that the perpetrator is a legitimate employee of a company or institution, yet enters into transactions on behalf of their employer without permission.
The effect on other traders
On a much smaller scale, the same thing can happen to an individual investment account. Not the fraud part, per se, but the compounding disaster from a "rogue trade."
In this instance, a small loss is allowed to develop into a bigger one: A bad investment is ignored, or even added to on margin, and so on. This is where the story takes on a sour note.
Here are some “rules of thumb” for keeping "rogue trades" out of your trading:
- Always know your exposure.
- Always know your risk points.
- Don't buy more without a plan.
- Don't forget correlation.
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