Chapter 16
Value Traders
Value traders supply liquidity
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Uninformed traders cause prices to deviate
from fundamental values
•
Dealers mistakenly respond to order flow
• Dealers adjust prices for inventory reasons
• Traders alone can cause prices to deviate from
fundamental values in order-driven markets
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How value traders respond
•
Supply liquidity (i.e., offer limit orders) to the
uninformed liquidity demanders directly
• Supply liquidity indirectly via dealers
Supply liquidity to the uninformed
liquidity demanders indirectly via
dealers: how?

Uninformed traders sell to dealers
→ Dealers accumulate inventories
→ Dealers adjust (lower) prices (because they do
not know whether traders are informed or not
→ Prices fall below fundamental values
→ Value traders trade (they take liquidity away
from the dealers in the form of immediacy, but
simultaneously supply liquidity in the form of size
(or depth).
Outside spread and its determinants
The prices at which a value trader is willing
to trade (they rarely quote these prices)
 Risk of value trading

Adverse selection risk – Informed traders
• The winner’s curse problem
•
Buy (sell) overvalued (undervalued) instruments
 Market impact

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Cost of value trading
•
Research expenditures
Outside spreads
Prices that value traders are happy to
accept when sell (A)
 Prices that value traders are willing to pay
when buy (B)
 Outside spread = difference between A
and B

More on the winner’s curse
Arises because the highest bidders tend to
be buyers who overestimate values
 To avoid the winner’s curse, bidders should
lower their bids more when bidding against
many buyers
 To avoid the winner’s curse, bidders should
lower their bids more when values are hard
to estimate
 You do not want to compete against foolish
traders
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Outside spreads are much wider
than dealer spreads due to
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The speed at which they trade
Size of positions (inventory risks)
Research costs
Exposure to adverse selection
Exposure to the winner’s curse
Total trading volume
Dealers earn the entire spread (from a round-trip
trade) while value traders earn half the outside
spread at most
Value traders vs. news traders
Both are informed traders
 Value (news) traders offer (take) liquidity
 Value traders should offer liquidity only to
uninformed liquidity traders, not to news
traders
 News traders must make sure that they are
trading on fundamental information that is
not yet in the price
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