InvestorQ : I understand that traders only create volatility in the stock markets. Is there any bigger role that traders contribute to the stock markets?
sara Kunju made post

I understand that traders only create volatility in the stock markets. Is there any bigger role that traders contribute to the stock markets?

3 years ago

A trader may often end up looking like a short term opportunistic punter and that is what traders specialize in. But did you know that they actually make life easier for investors and other participants in the market by sharing their risk? Firstly, how do you define a trader in markets? 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.

Look at any market crash in the world and traders take most of the blame. It is quite normal for traders to bear the chunk of the blame when the markets crash. It is 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 look at some very important functions that traders perform in ensuring the safety and robustness of the market. The role of traders is not just restricted to equity and F&O markets but they have a similar role in commodity, debt and forex markets too. Let us look at some of the key roles played by traders.

Traders tell you the monetary value of news flows and corporate announcements

Traders don’t normally get credit for this role but they surely play this role. 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. At least, they give a starting point.

Reduce market risk and make spread risk narrower in the market

How comfortable would feel to trade in the markets if there was a buyer for RIL at Rs. 1200 and a seller at Rs.1210. You will logically be scared to trade. The reason you don’t see such scary scenarios is because of the power of liquidity provided by liquidity. 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 markets more efficient by trading away anomalies…

If you always thought that traders only create volatility, then think again. Actually, it is these traders who make markets more stable and predictable. Let us understand this phenomenon by looking at the case of cash-futures arbitrage. Assume that the stock of RIL is quoting at Rs.1200 in the spot market but the near-month futures are quoting at Rs.1225. 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 are a kind of guide for small investors

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!

Short selling is actually good for the markets and traders do it

In the peak of the Lehman crisis, some countries decided to ban short selling. It backfired because in the absence of short selling, investors started to sell stocks and led to a vertical fall in the market. Short selling brings in traders on the sell side and reduces the chances of a vertical fall in stock prices. 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.

That is the reason it is said that 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. The next time you start blaming the traders for all your problems in the market, remember that they are the ones who are actually making the market safe for you.