basket 0 items @ £0
View Basket

Predatory Trading and Crowded Exits

Cover of  by James Clunie

Predatory Trading and Crowded Exits
New Thinking on Market Volatility
James Clunie

Every trader should have a thorough understanding of phenomena such as predatory trading and manipulation, and of liquidity problems that can arise when traders position themselves in a similar fashion to one another. These problems are often understood intuitively, but there is a benefit from understanding the theory behind them and from seeing the evidence of how they work.

In this new book, chartered financial analyst James Clunie looks at predatory trading, crowded exits, stop losses and manipulation. In each case, he considers the risks and opportunities that arise for traders.

Take predatory trading, for example. Predatory trading involves the exploitation of knowledge about the strategies and positions of other market participants. In particular, when a trader learns about another large player?s need to trade, an opportunity could arise to profit from the situation. The predator trades in such a way as to benefit from the market impact of forced transactions by the prey.

There are many reasons why a market participant might be forced to trade. One of the simplest of these is financial distress. Where a borrower runs into financial difficulties, this can result in a liquidation sale of the borrower?s assets at the behest of the lender. If the asset sales are large enough, they can have market impact. Knowing that a trader is in financial distress and that liquidation is imminent or underway, a predator initially trades in the same direction as the prey. This has the effect of withdrawing liquidity from the market. As a result, the market impact of the liquidation becomes greater than might otherwise be expected. The security price fall resulting from the liquidation becomes exaggerated, imposing losses on the prey. The predator then reverses his trading direction, exploiting the price over-shooting and closing out his position at a profit.

Market participants who begin to behave predictably or consistently ? particularly those big enough to get noticed ? are further common targets of predators. Index-replication funds are a good example of this. When companies are expected either to be added or removed from indices, predators go long or short in the build-up ? leaving index funds to buy and sell the stock in due time at the worst possible price.

Such trading of course raises ethical issues. Clunie clarifies the matter by bringing together legal, regulatory and industry pronouncements, feedback from experienced market practitioners and the results of tests using the Fisher and Lovell ethical-evaluation matrix. Predatory trading is ethical when it is based on publicly available or inferable information; the predators are truthful in their dealings with others; and the predator firm?s clients are not harmed. But predatory trading is unethical if it harms the firm?s own clients; if the predator is untruthful about his activities; or if the information driving the strategy is obtained through a breach of a firewall.

How might you benefit from it in trading?
Firstly by defending your own trading from predators ? they?re out there, they?re much more common than perhaps you think, and they can do you damage. Facts about your own market positions, cost basis, margin arrangements and capital strength can be valuable to others ? you make up part of the market ecosystem! It is sensible to exercise mild paranoia with respect to information about your own portfolio and capital resources. Remember that those who serve you, such as brokers and custodians, will hold information that others could find useful. This valuable information might be swapped in social settings and could be used against you in future. It should be protected as best as possible. Clunie also provides in-depth analysis of a variety of predatory trading methods; you can learn from the mistakes of former victims, and adjust your market positions and strategies accordingly.

You can also use these case studies to help adapt or devise your own offensive strategies. With index-fund predation, for instance, there is no reason why a trader can?t add this extra approach to their trading, and get the best possible price for their stocks in such circumstances.

Crowded exits are another danger or opportunity to be aware of. They occur in the following sort of scenario. You start to short a falling stock based on careful analysis. It keeps falling and you move into profit. Shorting rises off the back of this, and as the stock falls precipitately there is a short-seller feeding frenzy ? 16%, say, of the firm?s stock is now out on loan. Then macroeconomic data is released that suggests the economy will pick up, and with it, the company?s value. Other traders start to buy. The stock price rises ? fine, still, for your long-term shorting, but very painful for the large numbers who more recently got into the short. They place buy orders to cover their positions ? and this demand makes the stock rise even more. Even more short-sellers feel the pain and look to cover, too. But at this point, looking at the number of shares on loan (and thus potentially sold short) relative to normal trading volume, it becomes clear that not all short-sellers can cover their positions at the same time at the prevailing stock price.

So, should you join the rush to the door and try to get out now, or wait and suffer losses?

And what exactly is each share in the company worth right now? Meanwhile, the stock price is still rising?

With thorough analysis of how these incidents occur, Clunie suggests practical steps that short-sellers can take to mitigate this crowded exit risk, and how to actively be risk-aware when short-selling less liquid stocks with high days-to-cover ratios.

Clunie also covers the pitfalls of stop losses, manipulation and other perilous trading phenomena. In many respects all of these are, even now, only just beginning to be well understood. Traders can either be prey to those who exploit them, or well-defended and even (legally and ethically) able to take advantage of them too. The choice is yours. Predatory Trading and Crowded Exits is an exceptionally lucid and practical guide for those who wish to be counted amongst the victors rather than the victims.

View article on source website

Enter your email address to receive your free ebook

By requesting this free eBook, you agree to let us email you
about future Harriman House offers. We will not sell your details
to a third party and you can un-subscribe at any time.
A valid email address is required to receive your download link.