discrimination that large traders would otherwiseobtain. In continuous auctions, large traders typically split their orders so that they candiscriminate among the traders who offer them liquidity. They want to trade first with thosetraders offering the best prices and then, if necessary, with traders offering inferior prices.Splitting their orders thus produces a better average price than they would obtain if they had tofill their entire order at a single price. Front runners appropriate the benefits of pricediscrimination by taking liquidity from the traders offering the best prices. They then offer thisliquidity back to the large traders at inferior prices. The effect of a successful front-runningstrategy is to force large traders to pay more uniform prices to fill their orders.Under some very limited circumstances, front runners can be valuable to large traders. If frontrunners can find liquidity more cheaply than can large traders, the front runners may lower thecosts of trading large sizes. To be of value to large traders, front runners must consolidate the©2002 Oxford University Press
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Chapter 12Bluffers and Market ManipulationBluffers are profit-motivated traders who try to fool other traders into trading unwisely. Thebluffers then profit from those foolish traders. To trade profitably, you must avoid trading withbluffers.Bluffers use two techniques to fool their victims. Rumormongers spread information that theyhope will encourage people to trade as the bluffers want them to trade. The information may befalse information, or it may be true information presented in a manner or under circumstancesthat would cause traders to misinterpret it. Price manipulators arrange trades at prices, volumes,and times that they hope will change people's opinions about instrument values. The trades maybe real market trades properly arranged at arm's length, or they may be wash trades that theyarrange with confederates to create artificial market activity. Both bluffing techniques presentthe bluffers' victims with information that the bluffers hope will cause them to make falseinferences about values. In both cases, bluffers try to convince other traders that they are wellinformed traders.Painting the Markets
Traders say that price manipulators paint the tape when they trade to influence other traders.Traders coined this term when automated telegraph printers reported trades to off-floor traders.These printers—called tickers because of the sounds that they made—produced long paperribbons called ticker tapes. Traders who paint the tape cause the price record to appeardifferently than it otherwise would appear.Traders also say that price manipulators paint a picture when they produce information that doesnot reflect true market conditions. Manipulators hope that other traders will mistake theirpictures for reality.Market manipulation occurs when bluffers or their victims cause prices to change from whatthey would be if the bluffers did not pursue their bluffing strategies. Market manipulation isillegal in the United States and many other countries. It is very difficult to catch, however. If thebluffers do not openly fabricate information or arrange wash trades with conspirators, they oftencan easily defend themselves by claiming that they were engaged in legitimate trading strategies.Traders who offer liquidity to other traders must be especially careful not to offer liquidity tobluffers. To avoid losing to bluffers, liquidity suppliers must be very careful when they makeinferences about values from prices and volumes. If they make these inferences poorly, bluffersmay manipulate their trading and thereby profit. To fully understand how traders supplyliquidity, you must understand how bluffers discipline liquidity suppliers.This chapter starts with an illustration of a bluff. We then formally characterize bluffing. Wediscuss how bluffs work, why they sometime fail, and why regulators cannot easily enforce lawsagainst market manipulation. The chapter concludes with a discussion of the implications ofbluffing for traders who offer liquidity.
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12.1 A Long Side BluffBluffing is best introduced with an example. In the following invented example, Bill undertakesa long side bluff. In a long side bluff, a bluffer tries to profit by buying at low prices and sellinglater at higher prices. Our example has two endings. In the first ending, Bill successfullycompletes his bluff and makes great profits. In the second ending, value traders call Bill’s bluff,and he loses heavily.
After some careful research, Bill decides that the stock of a small firm named Bubbles NeverBurst (BNB) is a good candidate for his bluff. BNB is a young firm that has developed a newemulsifier with potentially valuable applications ranging from bathtub soaps to industrial foams.The stock is followed by many investors who are excited by its growth prospects. Most of themknow little or nothing about the underlying chemistry. BNB currently has no earnings and istrading for 5 dollars a share. The firm has 8 million common shares outstanding of whichmanagement holds 70 percent.Bill starts his bluff by buying BNB shares as quietly as he can. Using limit orders, he patientlywaits for the market to come to him. Because other traders also occasionally want to buy thestock, the price starts to rise. Over the next 40 trading days, Bill buys 200,000 shares at pricesranging from 5 dollars to 7 dollars. His average trade price is 6 dollars.On the 31st trading day, and continuing thereafter, Bill starts to praise the stock extensively inmessages he posts to various Internet message boards. He describes BNB's technology insubstantial detail as though he fully understood it. He also provides very optimistic cash flowprojections for applications of the technology. His messages draw heavily on informationpresented in BNB's most recent 10-Q and 10-K reports. He posts these messages using severaldifferent usernames so that it appears that the stock is widely followed. He even has his varioususernames spar with each other on the message boards to strengthen the impression that theyrepresent different people. Of course, his pessimistic usernames eventually concede winningpoints to his optimistic usernames.On the morning of the 41st trading day, BNB independently issues a press release that announcesthat it will be producing its new emulsifiers in China. The news is not surprising to anyone whoread BNB's last 10-Q report in which BNB provided a positive status report of its efforts toproduce in China. Several electronic news services receive electronic copies of the press release.Most news service editors run the story by publishing an exact or slightly edited copy of BNB’spress release.Bill sees the news immediately because he subscribes to a real time information service that hehas programmed to alert him whenever stories about BNB appear. Although the announcementhas no particular fundamental value, Bill quickly decides that it represents the opportunity forwhich he has been waiting. Bill immediately submits market orders to buy 50,000 shares ofBNB stock. He divides the orders into several parts and submits them to different brokerswithout telling them about the other parts. When the orders converge on the market, the pricerapidly rises. In 20 minutes, the price rises from 7 dollars to 10 dollars as Bill buys 50,000shares at an average price of 8.5 dollars. At the end of the hour, several news services arereporting that BNB is up substantially for the day on unusually large volume. BNB also appearson various electronic intraday lists of the largest daily price gainers.
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Bill also starts posting notes to the Internet bulletin boards about the importance of the Chinainformation. His notes now project price targets of 20 and 25 dollars per share, with thepossibility of more than 50 dollars a share by the time the new plant comes on line.12.1.1 The Successful Ending: Bill ProfitsSome traders who follow BNB closely see the price change. They immediately query theirelectronic information retrieval services to determine why the stock is moving, and when itstarted to move. They find the story about producing in China and see that the price increaseimmediately followed its publication.
Although the news has no particular fundamental value, many traders infer more from the storythan they should because of the large positive price change that followed the announcement.They mistakenly conclude that other traders believe that the story is extremely good news. Theyfoolishly ask themselves, "Why else would the market have gone up?" They convincethemselves that someone obviously thinks that the stock is a good value. In light of thisinformation, they then reevaluate their opinions about BNB. BNB’s technology now seemsmore promising, and the firm's prospects look much brighter than when they last thought aboutthe company. They say to themselves, "Because I certainly am among the first to see this news, Iprobably can still profit by buying BNB stock. If I wait too long, price will continue to rise, andI will have lost my opportunity." These traders then buy the stock. Since they are afraid thatothers may soon come to the same conclusion that they have, they submit market orders to tradequickly.Traders who buy when the market is rising and sell when it is falling are momentum traders.They are particularly susceptible to bluffs.These momentum traders primarily buy their stock from Bill! Bill lets the stock continue to riseto close at 12 as he sells 100,000 shares at an average price of 11 dollars.By late afternoon, the stock exchange has contacted the CFO of BNB about the price rise. Shereports that management is completely mystified by the events. The firm considers issuing asecond press release stating that they have no idea why their stock price is rising. BNB’sattorney, however, advises against doing so for fear of exposing the firm to lawsuits. Whennews service reporters call, management declines to comment stating that they have a policy ofnot commenting on market fluctuations.By the next day (Day 42), many other traders have seen the price rise. Some believe that itindicates that the stock may do very well in the future. Others have read Bill's notes on thevarious Internet bulletin boards and now agree that the stock probably is undervalued. Thesetraders also may have seen news stories reporting that BNB declined to comment on the burst inmarket activity. They interpret the refusal as a further indication that something is happening.These foolish traders try to buy the stock.Other traders believe that the stock may be overvalued, but most are not willing to act on theiropinion since they are not sure whether other, more significant, fundamental information mightaccount for the large price rise. Still others think that the stock is overvalued, but are unwillingto sell it because they expect that it will rise further.Bill sells heavily throughout the day, along with a few value traders. The stock peaks at 13dollars and then drops to 8 dollars on very high volume. Bill sells his remaining 150,000 shares©2002 Oxford University Press
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Part IVLiquidity SuppliersThis part of the book examines how and why traders supply liquidity to other traders. We startin Chapter 13 by discussing dealers. Dealers make markets. They allow other traders to quicklytrade small size. Dealers tend to be high frequency traders who do not know much about withwhom they trade or the fundamental values of the instruments that they trade.Chapter 14 then examines bid/ask spreads in dealer markets and in order-driven markets. Thediscussions in this chapter will help you to better understand the determinants of transactioncosts.Chapter 15 considers how block traders arrange large trades. Block traders find liquidity fortraders who want to trade large sizes. Block traders generally know their clients well.We consider value traders in Chapter 16. They are the ultimate suppliers of liquidity. Thesehighly informed traders often supply great depth when they believe that prices do not reflectfundamental values.We introduce arbitrageurs in Chapter 17. Arbitrageurs are informed traders who move liquidityfrom one market to the other. You must understand their trading strategies well to appreciate theeconomic effects of competition among market centers for order flows.Chapter 18 considers how public traders create order submission strategies. These decisionsdetermine whether they supply liquidity or take liquidity. When public traders are willing tosupply liquidity, they can often displace dealers.
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Chapter 13DealersDealers are merchants who make money by buying low and selling high. What you alreadyknow about merchants will help you understand how dealers in the financial markets tradeprofitably.Merchants may be dealers or distributors. Dealers buy from, and sell to, their clients.Distributors buy from their suppliers and sell to their clients. (In practice, many distributors arealso commonly known as dealers. Consider, for example, new car dealers.) Traders act asdealers when they make a market in seasoned securities or in contracts. They act as distributorswhen they help firms sell new securities or when they help a client sell a large block ofsecurities.All dealers face the same problems regardless of what they trade. They must set prices, theymust market their services to acquire clients, they must manage their inventories, and they mustbe careful that they do not trade with better-informed traders. The relative importance of theseproblems varies by what the dealers trade.Dealers in the financial markets supply liquidity to their clients who want to buy and sell tradinginstruments. They allow people to trade when they want to trade. They buy when their clientswant to sell, and they sell when their clients want to buy.Dealers make money by buying at low prices and selling at high prices. They lose money whenmarket conditions force them to sell at low prices or buy at high prices. These losses often occurafter they trade with informed traders.When dealers purchase something, they usually do not know to whom they will sell it or at whatprice they will sell it. If the price drops before they can sell the item, they lose money.Likewise, when they sell something, they usually do not know the price that they will pay torepurchase it. These unknowns make being a dealer challenging, exciting, and very risky.Dealers assume significant risks when they trade.Dealers are passive traders. Passive traders trade when other traders want to trade. Sincepassive traders do not control the timing of their trades, they must be very careful about how theyoffer to trade and to whom they offer to trade. They must ensure that when they do trade, theirtrades benefit them and not just their clients. Dealers must be especially vigilant to avoid losingto informed traders and bluffers.In this chapter, we will examine the principles by which dealers conduct their businesses. Youwill learn how dealers set their quotes, how they manage their inventories, how they respond toinformed traders, and how they learn about the values of the instruments that they trade. Theprinciples that we will discuss apply to all dealers whether they trade securities, commodities, orretail goods. If you are—or intend to be—a dealer, understanding these principles will help youmaximize your trading profits.Even if you have no interest in being a dealer, you must understand how dealers behave to tradesuccessfully in financial markets. Whether you trade with dealers or compete with them to offerliquidity, their trading decisions affect you. In particular, you must consider how dealers tradewhen you decide whether to take or offer liquidity.©2002 Oxford University Press
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In markets where dealers are the primary suppliers of liquidity, the cost of liquidity depends onthe factors that determine dealer profits. If you are interested in market liquidity, you mustunderstand how dealers trade, and when they are profitable.We start this chapter with introductory discussions about who dealers are, how traders negotiatewith dealers, and how dealers attract order flow. We then consider how dealers control theirinventories, and how they set their prices. The chapter closes by examining how dealers relate tovalue traders and to bluffers.13.1 Who Are Dealers?Dealers are profit-motivated traders who allow other traders to trade when they want to trade.The liquidity service they sell—immediacy—is valuable to impatient traders. Dealers profitwhen they buy from impatient sellers at low prices and sell to impatient buyers at high prices.The difference in prices compensates them for providing immediacy.
Many dealers are professional traders who work on the floors of exchanges or in the offices oftrading firms. These professionals sometimes use computer systems to support their dealing orto implement their trading strategies.Other dealers are individuals who access the markets through their brokers, often via Internetorder entry systems. Such traders generally supply immediacy by issuing limit orders. Theseindividuals often do not recognize that they are acting as dealers. They consequently do notalways fully appreciate the risks that they face and the circumstances under which they will loseor profit.Many markets officially register some traders as dealers. In exchange for some specialprivileges, these markets may require that their registered dealers supply liquidity. We discussthese arrangements in Chapter 24 (Specialists).Dealers often are known by other names. At futures exchanges, dealers are often called scalpers,day traders, locals, or market makers. At many stock exchanges and options exchanges, they areknown as specialists or market makers.Many dealers are also brokers. We discuss brokers and the dual trading problem that brokerdealers present in Chapter 7 (Brokers).In addition to offering liquidity to other traders, many dealers also speculate. Dealers sometimescan predict future price changes by inferring the reasons why traders demand to trade. They alsocan use quote-matching strategies to capture the option values of limit orders that they see. Inmany actively traded markets, competition among dealers may be so intense that dealers cannotprofit only by providing liquidity to customers. In such markets, dealers must speculatesuccessfully to stay in business. Dealers who must speculate to stay in business are sometimescalled position traders as opposed to spread traders. Spread traders profit exclusively frombuying at the bid and selling at the ask.In this chapter, we consider only how dealers supply liquidity. Although we discuss how dealersinfer information from the order flow, and how they react to it, we do not consider how they mayspeculate on it. Chapters 10 (Informed Trading) and 11 (Order Anticipators) examine thespeculative trading strategies that dealers most often employ.
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Because dealing can be quite risky, successful dealers tend to be traders who tolerate risks well.They generally do not enjoy bearing them, however. The risks of dealing are serious and scary.Many dealers have gone bankrupt because they assumed risks that did not work out. Dealersconstantly think about the risks that they bear and how to avoid them. Since bearing risk isunpleasant, dealers demand appropriate compensation when forced to bear large risks.13.2 Dealer QuotationsThe prices at which dealers are willing to buy and sell are their bid and ask prices. Dealersusually quote these prices to their clients before they trade. Dealers bid to buy at their bid pricesand offer to sell at their ask prices. Sellers receive bid prices when they sell to dealers, andbuyers pay ask prices when they buy from dealers. Ask prices are also known as offering prices.
Traders who want to buy from a trader who is offering to sell take the offer. Traders who wantto sell to a trader who is offering to buy hit the bid.Dealers always set their ask prices above their bid prices. The difference between the ask andthe bid is the bid/ask spread. When the ask is close to the bid, the spread is narrow, or tight.When the ask is much higher than the bid, the spread is wide.Dealers make money by buying low at their bid prices and selling high at their ask prices. Thisstrategy is profitable if dealers can fill orders on both sides of the market without changing theirprices. In practice, this strategy is quite difficult to implement profitably because dealers rarelyreceive buy and sell orders in equal volumes, and because unforeseen price changes are verycommon.The realized spreads that dealers earn are often smaller than their quoted spreads. The realizedspread is the difference between the prices at which dealers actually buy and sell. Realizedspreads are usually smaller than quoted spreads because dealers occasionally trade at betterprices than they quote and because dealers often adjust their bid and ask prices between trades.Example of a Small Realized Spread
Dell is a dealer who is bidding 35.0 and offering 35.3 for a security. A client arrives and sells atDell’s bid of 35.0. Dell now needs to sell the security to restore her former position.Bad news about the fundamental value of the security subsequently arrives. To avoid buyingfrom well-informed traders, Dell must lower her bid to 34.6. To encourage traders to buy fromher so that she can sell the security, she must lower her ask to 34.9.A buyer arrives and buys from Dell at 34.9. Although Dell’s quoted bid/ask spread before bothtrades was 0.3, the realized spread for her roundtrip buy and sell was −0.1 = 34.9 − 35.0. Delllost money because she was holding the stock when its value dropped.Dealers who quote both bid and ask prices quote a two-sided market. Their quotes make amarket. Those who quote only one side quote a one-sided market. Although most dealers willquote a two-sided market, they usually aggressively price only the side on which they wouldprefer to trade. For example, dealers who want to buy usually quote high (aggressive) bid pricesto encourage sellers to sell to them. They also quote high uncompetitive ask prices to discouragebuyers from buying from them. Dealers who want to sell likewise quote low bid and ask prices.
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Chapter 14Bid/Ask SpreadsThe bid/ask spread is the price impatient traders pay for immediacy. Impatient traders buy at theask price and sell at the bid price. The spread is the compensation dealers and limit order tradersreceive for offering immediacy.The spread is the most important factor that traders consider when they decide whether to submitlimit orders or market orders. When the spread is wide, immediacy is expensive, market orderexecutions are costly, and limit order submission strategies are attractive. When the spread isnarrow, immediacy is cheap, and market order strategies are attractive. If you are interested inoptimizing your order submission strategies, you must understand what determines bid/askspreads so that you can judge whether they are wide or narrow, given current market conditions.The spread is also the most important factor that dealers consider when they decide whether tooffer liquidity in a market. If the spread is too narrow, dealing may not be profitable, and dealersmay quit trading. If it is wide, dealing will be profitable, and other dealers may enter the market.If you are interested in dealer profitability, you must understand the factors that determinebid/ask spreads.In this chapter, we will consider what determines bid/ask spreads in dealer markets and in orderdriven markets. We will discuss when immediacy is expensive, when it is cheap, and why. Themost important factors that determine spreads are adverse selection due to well-informed traders,volatility, and market activity. We will closely examine these factors and many others.The most important lesson you may learn from this book appears in this chapter. You will learnwhy uninformed traders lose to well-informed traders whether they submit limit orders or marketorders. Uninformed traders lose simply because they trade. If you are an uninformed trader anddo not want to lose, you should minimize your trading.14.1 Dealer Bid/Ask SpreadsDealers set their spreads to maximize their profits. Their spreads must be wide enough to allowthem to recover their costs of doing business. Otherwise, they will not be profitable, and theywill quit dealing. Their spreads cannot be so wide, however, that no one would trade with them.Their revenues then would not cover their expenses.
Dealers profit when their revenues exceed their expenses. Dealer revenues depend on theeffective spreads they earn on their roundtrip trades, on how often they can turn their inventory,and on how much they lose to informed traders. Dealer business expenses reduce their profits.Dealer expenses include financing costs for their inventories, wages for their staff, exchangemembership dues, and expenditures for telecommunications, research, trading systemdevelopment, clearing and settlement, accounting, office space, utilities, and other such items.14.1.1 Monopoly DealersWhen dealers face little competition, they may quote wide spreads to maximize their profits.The optimal monopoly spread depends on the demand for their services. If clients are willing to
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trade regardless of the spread, spreads will be wide. If clients are sensitive to their transactioncosts, spreads will be low.Monopoly dealers set their spreads so that the additional revenue from a slight decrease in spreadis just equal to the additional cost of providing the additional liquidity that traders will demand atthe slightly lower spread. A similar result appears in all introductory economics textbooks. Wewill not explain it here because dealers can rarely behave as monopolists in financial orcommodity markets.Monopolies are successful only when monopolists can prevent other competitors from enteringtheir markets. In most security and contract markets, the barriers to entry that dealers face arelow. Dealers always look for markets in which they can make money. If dealing profits areexcessively high in some market, they will enter that market and try to participate in the excessprofits. Their entry tends to lower spreads and thereby the profits of all dealers in the market.The threat of entry therefore may prevent a dealer from behaving as a monopolist even when noother dealers are in the market.In many markets, dealers also face competition from public limit order traders. Limit orders areessentially the same as dealer quotes. Both are offers to trade that other traders may take whenthey want to trade. Dealers who compete with aggressive public limit order traders cannot earnlarge effective spreads because the limit order traders will undercut their quotes.One Dealer Does Not Necessarily a Monopolist Make
The specialists at the New York Stock Exchange are the unique dealers in their specialty stocks.Although their unique positions may give them some market power on the floor of the Exchange,they are hardly monopolists. They face competition from public limit order traders and fromdealers at other exchanges that trade the same securities.14.1.2 Spreads in Competitive Dealer MarketsIn competitive dealer markets, dealer spreads ultimately depend on the costs that dealers incurrunning their business. The free entry and exit of dealers ensures that spreads will adjust so thatdealers just earn normal profits for providing their liquidity services. When spreads are too highso that incumbent dealers earn excessive profits, new dealers will enter the market. Theircompetition for order flow will cause spreads to fall. As the spreads fall, so will the excessprofits. If spreads are too low so that dealers are losing money, some will eventually quit sincenobody can lose money forever. With less competition, the remaining dealers will be able toraise their spreads and thereby decrease their losses. Only when spreads are set so that dealersearn normal profits will dealers neither enter nor leave the market.
Dealers earn normal profits when their revenues just cover their total economic costs of doingbusiness. These costs include all costs described above, a fair rate of return on their investedcapital, and fair compensation for their entrepreneurial efforts. Economists call the differencebetween revenues and the total economic costs of doing business economic profit. When dealersearn normal profits, economic profits are just zero. Firms that make normal profits haveaccounting profits that just cover the value of the entrepreneurs’ time and the rental of theircapital.
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14.2 Spread ComponentsFor analytic purposes, economists break the bid/ask spread into two components. Thedecomposition makes it easier to understand what factors determine bid/ask spreads.
The transaction cost spread component is that part of the bid/ask spread that compensatesdealers for their normal costs of doing business. We enumerated these costs above. Thiscomponent also funds any monopoly profits that the dealer may make and any risk premium thatdealers may require for bearing inventory risk.The adverse selection spread component is that part of the bid/ask spread that compensatesdealers for the losses that they suffer when trading with well-informed traders. This componentallows dealers to earn from uninformed traders what they lose to informed traders. We alsodiscuss this component in Chapter 13 (Dealers) when we consider how dealers learn about valuesfrom the order flow. There we examine the component from an information perspective. Herewe examine it from an accounting perspective. Although the two perspectives are quitedifferent, remarkably, both perspectives imply the same sized adverse selection spreadcomponent.The two components taken together constitute the total spread. Dealers never separately quoteboth components. They simply quote their bid and ask prices. To actually estimate the twospread components, analysts must use econometric methods.14.2.1 The Transaction Cost ComponentIf all traders knew instrument values with complete certainty, the transaction cost componentwould constitute the entire spread. Prices would simply bounce back and forth between bidprices, which would be set slightly below instrument values, and ask prices, which would be setslightly above instrument values. Competition among dealers would cause the spread to equalthe normal costs of doing business. If dealers had monopoly power, they would set widerspreads.
Economists also call the transaction cost spread component the transitory spread componentbecause price changes associated with this component are transitory. Transitory price changesregularly reverse. Price changes caused by a jump from the bid to the ask most frequently followprice changes caused by a jump from the ask to the bid. Such price changes occur when theorder flow includes a mix of buyers and sellers.Traders call the bouncing back and forth between bid and ask prices bid/ask bounce. Bid/askbounce is a minor form of price volatility caused by impatient traders who demand immediacy.The transitory spread component is responsible for bid/ask bounce.14.2.2 The Adverse Selection Spread ComponentSince dealers do not know fundamental values well, they expose themselves to adverse selectionfrom better-informed traders when they offer liquidity. The better-informed traders choosewhich side of the market on which to trade, and the dealers end up losing money to them. Whensome traders are better informed than are other traders, traders are asymmetrically informed.
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Chapter 15Block TradersBlock trades result from orders that are too large to fill easily using standard trading procedures.Such orders generally demand more liquidity than is normally available at exchanges or in dealernetworks. Traders who wish to trade large blocks therefore must look elsewhere for liquidity.They usually turn to block traders to arrange their trades.Block traders include block dealers and block brokers. Block dealers arrange block trades whenthey fill their clients’ large orders. Block brokers arrange block trades when they find othertraders who are willing to fill their clients’ orders. Both types of block traders usually arrangetheir trades by telephone in the upstairs block market