Trading Size

Check out this video, I was reminded of it while studying for my trading exam this Saturday. After taking Burnside's class I have a lot more appreciation for what this teddy bear does, and the hurdles he faces. 

Types of Traders

Traders come in three main types (so say the academics), Noise, Informed, or Liquidity. Informed traders trade because they have valuable information about a security that isn't impounded in the price yet, and they place the position accordingly. Noise traders are traders who think they are informed, but are mistaken and are actually taking a bet against the true price. Liquidity providers are traders who step in and buy and sell a security with the goal to only make a spread between their buys and sells, or they are traders who place limit orders to buy or sell at certain prices. The former liquidity trader is usually a market maker, and the latter can be anybody,. 

The size trading teddy say's he's a liquidity trader, but what he really means is that he is a informed trader. Chances are most of his orders are "market orders" and so he is actually liquidity taking, not liquidity providing. 

Motivations to Trade

There are five main reasons people trade in the market.

• Information: Investors may have "slow ideas" based on fundamental analysis that suggest the stock is mispriced, and they will buy or sell hoping it reverts to the true price over a period of time. Traders may have "fast ideas" based on a wide variety of methods that may suggest the stock is either temporarily mispriced, or is about to move in a certain direction, and they will buy or sell hoping to catch that move.
• Liquidity: Most liquidity trades are made for reasons that have nothing to do with future outlook of the stock. Index’s that track a benchmark need to trade to avoid tracking error, mutual funds need to rebalance holdings, hedge funds need to adjust their holdings to keep certain risks neutral. Any trade that is of this nature can be labeled a liquidity trade.
• Noise: As mentioned above the market is full of traders who think they know something but actually don't. Their volume helps informed traders move size, and so they are an essential part of the markets efforts to decrease transaction costs. 
• Tax: Many individuals and funds sell at strategic times to push capital gains taxes around or to avoid dividends.
• Agency Conflict: Mutual funds hate to show their holder's stocks that have had big negative returns, and so before the report goes out many funds sell their losers. This is called "window dressing"

Transaction Costs

I had always thought of transaction costs as that commission fee I pay every time I buy or sell a stock. Turns out that is part of it, but there are two other costs that can be much harder to see that also play a role. The total transaction cost or "implementation shortfall" is made up of commissions and fees, the execution cost, and the opportunity cost. Execution cost can be thought of the difference between the average price per share you receive and the midpoint between the bid and ask right before you traded, and opportunity cost can be thought of the difference between the midpoint when you decided you wanted to trade the stock, and the midpoint right before you started trading. For small traders these extra costs are small, but they can be enormous for large traders, and the trouble with trading is that if you do well you get bigger.

Think of it this way. Let's say you have decided to spend a lot of time researching oil junior stocks to look for mispricing’s, you figure (correctly) that this small cap sector of the market won't have as much coverage and the chance to find a mispriced stock will be easier. Let's say you find a stock that is priced at $1.00/$1.05 (bid/ask) and you think it should be priced at $1.25. You want to buy 10000 shares of it. On paper you expect to make (1.25-1.025)*10000=$2250, but how much might trading cost you? As an oil junior the stock is thinly traded, average volume of 10000 per day, so you know there is no way you can buy all 10,000 shares at once. Let's say you decide to break it into 4 blocks, and trade in 4 consecutive days. Possible trades could go as follows:

• Day 1 Stock at 1.00/1.05, Buy 2500 @ 1.075
• Day 2 Stock at 1.05/1.10, Buy 2500 @ 1.10
• Day 3 Stock at 1.12/1.17 Buy 2500 @ 1.20
• Day 4 Stock at 1.15/1.20 Buy 2500 @ 1.20

On day 2 and 4 I assume enough liquidity that you can fill at the ask, but on days 1 and 3 you need to eat into the limit order book to fill the entire order. The spread is assumed at 0.05 which is a bit wide, but definitely not unheard of for small thinly traded securities. The costs break down as follows, your average price is $1.14375 and so the total implementation shortfall (assuming no commission) is (1.14375-1.025)*10000 = $1187.5. This is more than half of your expected profit, and we have only gotten half way through the transaction, we still have to sell! The opportunity cost is captured by how the security moved up as you scaled in over 4 days (very typical with heavy buying), and the execution cost is captured by the difference between the execution price and the midpoint. 

Problems with Trading Size

• Latent Demand Problem - When you are trading a significant portion of a stocks average daily volume, it can be tough to find enough counterparties to fill your trade. In searching for these parties you are forced to show the market your intended order size, or experience 'order exposure'.
• Order Exposure - Leakage about your order causes the market to move away from you because traders expect your liquidity needs to creep through the limit order book and they want the best price, and traders may think you are informed (what do you know that makes you want to take such a large position). 
• Price Discrimination - Traders will assume that because you are trading a large block of stock, you will trade another block shortly afterwards. This is very common in sell orders, panicking investors (informed or noise) will try to hide their costs by breaking up huge sell orders into smaller blocks, so traders learn to treat a block of any size with suspicion.
• Asymetric Information - If you know you will suffer the costs described above and you are still willing to trade size, you must know something (or so the market assumes). Even before doing their own homework, the market will side with your bet and the price will move away from you, because traders will assumed you are informed. 

The Winners Curse and Where Trading Still Works

As you can see from above, if you are a successful trader transactions costs will quickly become the nemesis of your strategy. As you get larger you will have trouble with your block orders, and if you start to gain a reputation of being successful the market will move as soon as you place your first order. This winners curse has an interesting selection aspect to it, if you are too good you kill your strategy, if you are bad you go bankrupt, if you are just okay you might be able to float along undetected at a reasonable size and scratch a living. 

There are ways to trade size, and a huge mutual find called Dimensional Fund Advisers manages to do it in the toughest of markets. Talking about how they do it is a blog within itself, but the essence is simple. They invest entirely on a passive strategy that rests on the principles on the Fama-French 4 factor model; assets have risk that is characterized by beta, size, value, and momentum. Small companies are riskier than large companies, and value is riskier than growth. The genius of the strategy from a trading sense, is they are proudly uninformed. They don't care what they buy (to a certain extent) and so they happily take hard to trade small cap stocks off active investors hands for a small haircut, when otherwise the market would fleece both with transaction costs. DFA gets the stock with negative transaction costs (profit), and the active investor saves a bundle on shortfall. The real interesting part is that through the 90's DFA made more money on this trading strategy, than it make on its investment strategy - and it's a passive fund!