Crashes Can Be Avoided If Traders Move Slowly
Wall Street traders make the most money when they do their best to stay under the radar of other traders by making their trades slow and steady. This strategy also keeps the market from crashing, according to new research from the University of Maryland’s Robert H. Smith School of Business.
Albert “Pete” Kyle, the Charles E. Smith Chair Professor of Finance, and Yajun Wang, assistant professor of finance, along with Anna Obizhaeva of Moscow’s New Economic School, wanted to pinpoint the best trading strategies to achieve equilibrium in the market. They determined that gradual movement toward a target inventory is the optimal strategy. Kyle says traders, trying to make the most money on their transactions, typically spread their buying and selling out over a period of hours, days or weeks to stay under the radar of other traders. Traders assume their counterparts are also taking this slow-and-steady approach. But most are so confident that they have better information that they make price adjustments accordingly while continuing to trade.
Kyle explains that a trader’s target inventory changes based on a stock’s price and the information he or she has about the stock. If the price falls, a trader can up his target because he can buy it more cheaply. Traders determine how fast to buy or sell based on how far the price is from what they think the asset is worth.
Kyle points to Warren Buffet as the most obvious example of this mentality, buying the same stock for very long periods of time – sometimes months or even years – to avoid moving the price too much.
Problems occur when traders do not play by these rules.
“If you don’t try to stay under the radar and you trade rather quickly to your target inventory, the other traders in the market would assume that you had some fantastically big information and the price would react very violently if you tried to do that: a flash crash,” says Kyle. This is what happened in the 2010 Flash Crash, a 36-minute stock market crash where markets plunged 998.5 points then rebounded.
The research explains that stock prices are set by how much traders have bought in the past, affecting the price through permanent price impact. But the price is also a function of the rate at which traders are buying currently. Buying a lot today will push the price higher today, but if traders stop buying at the end of today and don’t buy tomorrow, the stock will fall back down and probably open lower the next day, called temporary price impact.
“We’re hoping that this model will make it a much more accepted idea that temporary price impact is something you should worry about,” says Kyle. “We think that most smart institutional traders appreciate that temporary price impact is an important component of transaction costs — maybe the main component.”
The research advocates for the slow-and-steady trading strategy, which Kyle says most sophisticated large traders are already implementing. “There are other traders who fail to appreciate either how liquid or how illiquid markets are,” he says. “They will go into a market and think that it’s going to provide them more liquidity than it actually does, and that’s what leads to these little transient flash crashes that occur every now and then. We think this model could play a role in educating people that flash crashes are something that they themselves can cause if they aren’t paying attention.”
Read more: Smooth Trading with Overconfidence and Market Power is featured in the Review of Economic Studies.