Are We Underestimating the Role of Investors in the Stock Market

How exactly do you define a trader in markets? Frankly, there are no hard and fast definitions but a trader typically tries to move in and out of markets to capitalize on opportunities. Essentially a trader has a short term perspective. This can range from a single day to a couple of months but the role of a trader needs to be understood as distinct from an investor who typically allocates money for the longer term. It is quite normal for traders to bear the chunk of the blame when the markets crash. It is often alleged that overtrading or short-selling by traders led to bubbles which eventually led to value destruction in markets. While this could be partially true, it is also largely unfair to traders. The focus here is to dwell upon some very important functions that traders perform in ensuring the safety and robustness of the market. Remember, while our focus here will be on the equities market, the role of traders is similar in commodity, debt and forex markets too.

• Traders assign monetary value to news flows…

This is often the less understood role that traders play in the markets. If the central bank decides to cut rates by 50 basis points or if a company reports better than expected quarterly results, what value should be assigned to the impact on price? Frankly, there are no hard and fast rules for such an interpretation. That is where traders come in. By taking a series of short term views on the stock, these traders eventually assist in price discovery. In the absence of traders, it will be very difficult for the market to assign a monetary value to the impact of news flows.

• Traders reduce risk by creating narrow spreads on stocks…

Do you remember a time when trading spreads on a stock like SBI and Tata Motors could be Rs.2? In normal markets, the spread in case of such stocks would be at best 5 paisa to 10 paisa. But on extremely volatile days like we have seen when stocks have been extremely volatile, traders tend to keep off the market. That is when you get to see spreads widening. But how do traders narrow spreads on a stock? Consider a situation where there are no traders in a stock. The buyers is standing at Rs.75 and the seller is standing at Rs.79. Obviously, if the buyer and seller stick to their guns, then there will be no volumes on the stock. That is when traders enter the fray. By identifying trading opportunities, traders provide buy and sell liquidity for much shorter ticks. When the spread comes down from Rs.4 to 10 paisa, both the buyer and the seller have an incentive to execute their limit orders as market orders since risk is quite low. That is how risk in markets gets reduced by traders and volumes are built.

• Traders make the market more efficient by trading away anomalies…

Let us understand this phenomenon by looking at the case of cash-futures arbitrage. Assume that the stock of RIL is quoting at Rs.1500 in the spot market but the near-month futures are quoting at Rs.1530. That is probably because some large investor has sold a chunk of Reliance shares that has led to the spot price going down. Traders will immediately see that the arbitrage spread between spot and futures is as high as 2% a month. They will immediately buy RIL in the spot market and sell in the futures market. This way they earn an assured return of 2% for the month but also ensure that anomalies in the market are traded away, making price discovery more reliable.

• Traders act as a beacon for retail investors to follow…

For most retail and small investors, the big risk in any mid-cap stock is whether they will get the liquidity to exit the stock. If the stock has gained Rs.10 and if the individual was to lose Rs.4 due to inadequate spreads, then retail investors may not be too inclined to invest in equities at all. This shortfall is covered by traders. Most domestic traders tend to operate in the mid-cap space and hence trading volumes become a very important lead indicator for retail investors to safely get into a stock. While the individual investor does not have to follow the trail of the trader, the presence of traders in any counter surely gives confidence to retail investors to trade without worrying about liquidity; or rather the absence of it!

• Traders on the short side can actually prevent vertical crashes…

During the peak of the post-Lehman sell-off in markets, many European markets contemplated a blanket ban on short selling. Fortunately, good sense prevailed and the moves were not pursued aggressively. Remember, that is where short sellers come in! When traders see down side opportunities in the market, they sell the stock short i.e. they sell without delivery but cover during the day. This has two implications for markets. Firstly, it does not lead to panic delivery selling in the market, which could result in steep losses for investors. Secondly, since traders normally sell short, they will be required to cover their positions and this short covering will provide support to the markets. Actually, the actions of traders ensure that market is saved of severe disruptions.

In a way, the short term traders are the life-line of markets. Long term investors and small participants actually survive in market due to the constant liquidity support provided by traders. Their role in any market cannot be underestimated!