Tuesday, September 24, 2013

Inside information

Some traders got 'no taper' decision news earlier

Well, not necessarily.  It does seem that way though.  But just suppose that someone decided right before the announcement to make a big bet on the announcement.  It's not that unreasonable to think that someone looked around and realized that the market had already priced in the taper.  It isn't unreasonable to make a bet against something if you think that something has already been priced by the market.  So... right before the announcement is made public, you place a bet that the announcement is going to be not what everyone expects.  If you're wrong, there's not much to lose.  If you're right, though, the gains can be big.  There is asymmetry between potential gains and losses.

So, some big player places their bet a fraction of a second before the announcement is made.  And the high frequency traders are all over it, since their program may assume that somebody knows something and an increase in buying means there was a leak.  They jump on the bandwagon, and they're all winners in this case, because one person (or more) decided to the potential reward outweighed the risk.

But then again, maybe it was a high frequency trader that decided to place a bet a little bit early, thinking that other high frequency traders would jump in on their buying.  Then, if the announcement was against them, their program could close their position and still make a gain.  For the first trader, the only risk is that others won't follow suit.  They know that they traded without inside knowledge, but they're the only ones that know that.

The point here is really that investors shouldn't pay an awful lot of attention to headlines.  This particular headline says that some traders got the news early.  But in order to make this trade work, all that a trader needed to do was to make it look like they had inside information.  And in a way they did.  The inside information was that they didn't really have inside information.  Or, maybe they did.

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