The Dilemma of the Impatient Trader

In this essay, we want to argue a result of any market that individuals trade in. We recognize that such markets are dynamic or complex adaptive systems and as such we lack the tools to effectively determine quantitative results. We use a very simple case to derive our arguement from but we feel that contained within the simplicity is a kernel of truth. Our argument is that in any market, impatience costs money.

We start with a market in some asset with patient buyers and patient sellers. By patient we mean a market participant who has determined a value for an asset and is willing to trade – either buying or selling – at that price. He is willing to wait until he gets it which may be never. Further, we assume he will never change his mind.

Now to forestall objections, we realize that in a real market, participants are constantly entering, dropping out of and reentering the market and adjusting their price or valuation particularly in terms of market action. We don’t think such a market can be effectively modeled although we have used simulation tools to generate emergent behavior in simple complex adaptive systems that might be instructive. Hence this simple model.

In our simple market, different quantities of the asset are offered at different asking prices by patient investors.  At any price there may be one or several participants offering lots of different sizes. The entire range of prices asked and the corresponding quantities offered comprise the market depth on the sell side. A similar situation exists on the buy side. The difference between the lowest selling price offered or asked and the highest buying price bid is called the bid/ask spread. We will ignore the role of market makers.

The market described is static. No trades are taking place. But suppose a new market participant comes in wanting to buy the asset and is impatient meaning he wants to quickly complete his trade without concern for the price. The patient investor waits for the trade to come to him. The impatient investor takes the trade to patient investors. This participant may have personal knowledge that he believes is generally not widely understood or known and results in a higher valuation than the lowest price offered. Suppose further that this participant wants to acquire an unusually large position.

Rather than placing an order to buy and waiting to see if it will be filled by an impatient seller or a natural market revaluation (we discuss this idea later), the impatient trader starts buying at the lowest price offered, working steadily upwards in price and taking orders out of the market until he has the quantity he wants. The result is his average unit price for the asset acquired is higher than what the lowest selling price was at the start. He has paid a premium to acquire his position. If he is in a hurry or wants to acquire a very large position, he may drive the price much higher.

The same happens on the downside. There is market depth of patient buyers. Suppose the above impatient buyer is suddenly forced to sell all of his acquired assets. As he disposes of his position he drives the market price down. He takes a real hit on the downside. The total cost to this impatient trader is the spread between his average buy and average sell price which may be substantially greater than the bid/ask spread of the quiet market.

Real Markets

We have used this simple model to try and describe a general feature of markets. It’s action is easiest seen in illiquid markets where the market depth is not great. That is the volumes of assets available to be bought or sold are low and/or the number of market participants is low. Large price spreads may result and acquiring or divesting a position may cost large premiums.

An important player in real markets is the participant, often referred to as a ‘trader’, who is not interested in acquiring assets but is interested in making money on buy/sell spreads and price movements due to market activity. These are impatient traders but a better term for them might be ‘active’ traders. They are responsible for a lot of market activity and perhaps most of market activity. In some markets they are called “speculators”.

We have characterized the patient participant as one who never changes his valuation and therefore the position of his bid/offer in the market. Such a person however may be regularly reviewing the conditions of his valuation and may change his market order accordingly. Part of his valuation may be the general level and activity of the market.

The original reason for creating a patient participant was to create a time-frame in which only the impatient participant would be active allowing us to illustrate how the premium such a participant incurs arises. A market that adjusts naturally over time but sufficiently slowly may still allows our modeled behavior to function.

Implications

This becomes an important consideration for market players that have very large positions or want to effect the market for reasons other than asset acquisition or disposal (e.g. interest rate manipulation by central banks).

As one example, consider the common theme that the Chinese may “dump” their Treasury holdings for whatever reason. As of June 30 2012, China held $1.164 trillion in US Treasuries (Tracking the Ownership of US Debt). To dump or dispose of this position in a short period of time would drive prices down causing a potentially sizable loss in foreign exchange in the process. There are other reasons why the Chinese would not do this but losses accruing to an impatient seller would be an important one. It is not clear that a market even exists for a position of this size. We note that yields on Treasuries would rise dramatically having major effects across global economies and markets and inviting action by central banks to restore market equilibrium.

The other case is that of central banks themselves. In recent years, central banks have expanded their balance sheets by very large amounts acquiring debt assets in the process as impatient buyers. They will likely sustain appreciable losses as they try to unwind these positions as impatient sellers. It all depends on how fast they may have to unwind their positions. There remains a possibility they may not be able to deflate their balance sheet in the short to mid term, if ever.

The dynamics of the debt they hold may mean in many cases, that economic growth will be suppressed for decades (Some Thoughts on Debt Saturation and Growth and referenced posts). To raise interest rates depresses economic activity. The banks simply may not be able to exit their positions except very slowly and stealthily so as to avoid raising rates and forcing fragile economies into recession.

 Fed Problems

The Fed’s balance sheet was the motivation for developing this idea: that as an aggressive buyer and seller, the Fed would would pay the premium that the impatient trader pays, potentially becoming technically insolvent. Zero Hedge posted another argument on how Fed actions are impairing its balance sheet: The Fed’s D-Rate: 4.5% At Dec 31, 2013… And Dropping Fast. In it the author argues that the structure of the balance sheet has the Fed posed on the brink of interest income deficits should rates rise much. The argument is that the Fed has created a long duration fixed rate asset structure while maintaining a large reserve liability that is technically of a variable rate potential. If rates rise, the Fed must raise rates paid on the reserves or risk a large inflationary regime as reserves seek higher returns in the public market.

 

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