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Liquidity, overpricing, and the tactics of informed traders

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Abstract

In this paper we explore the profit-taking tactics employed by informed traders when there are informational asymmetries across investors. Our laboratory is Tradesports, which until 2015 operated a double auction exchange where participants traded binary options contracts. This venue is a close analog to stock markets and, because each contract’s value is unambiguously revealed, the joint hypothesis problem is mitigated. We demonstrate that when the ratio of noise traders to sophisticated traders is highest, shares are most overpriced. Data show that informed traders heavily target noise traders when liquidity is high, and in conducting profit-taking operations they prefer to short sell via small transactions and round lots. Results suggest that, even in the absence of liquidity constraints and certain costs and risks related to short selling, the relative complexity of short selling can itself lead to overpricing.

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Notes

  1. It is noteworthy that contracts are significantly overpriced in each of the first three price quintiles. Theories developed by Kahneman and Tversky (1979) and Prelec (1998) suggest that an s-shaped pattern should emerge with a point of inflection around $37, but here the point of inflection first occurs at around $66 (see Fig. 1).

  2. http://www.businessinsider.com/most-watched-sporting-events-of-2015-2016-1

  3. O’Connor and Zhou (2008) and Tetlock (2008) find that aggregate trade volume is a good proxy for liquidity in prediction markets.

  4. Prior equity research has examined the informativeness of lot size rounding, and evidence suggests that round-quantity trades have greater price impact than do unrounded trades (Alexander and Peterson 2007).

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Authors and Affiliations

  1. Department of Finance, University of South Florida - Sarasota, 8350 N. Tamiami Trail, Sarasota, FL, 34243, USA

    Richard Borghesi

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  1. Richard Borghesi
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Correspondence to Richard Borghesi.

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Borghesi, R. Liquidity, overpricing, and the tactics of informed traders. J Econ Finan 41, 701–713 (2017). https://doi.org/10.1007/s12197-016-9375-5

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  • DOI: https://doi.org/10.1007/s12197-016-9375-5

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