The Effects Of Institutional Risk Control On Trader Behavior

Ryan Garvey

Duquesne University

Fei Wu

Shanghai Jiao Tong University (SJTU) – Shanghai Advanced Institute of Finance (SAIF)

December 3, 2015

Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 18, No. 2, 2008

Abstract:

We examine how institutional risk control mechanisms influence proprietary stock trader behavior. When traders are forced to liquidate their inventory at a pre-designated time, they often hold onto their losing trades until the very last moment. We find that the difference between losing and winning round-trip holding times systematically widens leading up to an inventory liquidation deadline and trading becomes less driven by trading practices and more induced by the firm’s control mechanism as the deadline draws near. When trade price is heavily controlled yet trade size isn’t, we find that the difference between losing and winning roundtrip holding times systematically widens with trade size. This result suggests traders increase their risk-taking in areas where institutional control mechanisms are weaker. Our findings highlight the difficult balancing act firms face with getting market professionals to realize their losses without impeding their trading strategies.

The Effects Of Institutional Risk Control On Trader Behavior – Introduction

A considerable amount of research has uncovered behavioral biases among financial market participants.1 In order to circumvent these biases and help employees make better decisions, financial institutions implement risk control mechanisms with their employees who make trade decisions with institutional capital. The contributions of this study are: 1) to examine how effective control mechanisms are at mitigating psychological trading biases, and 2) to examine how employees respond to control mechanisms.

While our results are useful for firms implementing or planning to implement risk control mechanisms, our results also provide a step forward for the academic literature. Much of the academic literature has been devoted to uncovering behavioral biases in various settings and among different types of market participants. Uncovering these biases is, of course, a necessary first step. Yet, some trading biases are well known and firms have been grappling with ways to control them for decades. Despite this, there is very little research that examines trader behavior in settings where prevention techniques are actively implemented by firms to get their employees to recognize and refrain from biases in their decisions.2 In our paper, we examine such a setting.

We analyze how proprietary stock traders, who work on behalf of a National Securities Dealer, react to institutional control mechanisms that are primarily intended to get them to realize their trading losses. It is well known that market professionals often have difficulty coming to terms with their losses. Consequently, they have a tendency to hold their losing trades too long because they want to recover from their losses. This desire to get even is quite persuasive in financial market settings, and it is inevitably ingrained in many of the everyday decisions that traders make. Indeed, some of the greatest trading losses of all time have occurred because traders were simply unwilling to take a loss, so they gambled in an attempt to recover from their loss.3

In order to help traders come to terms with their losses, our sample firm implemented several control mechanisms. The most binding of these control mechanisms was that they required traders to liquidate their inventory by the end of the trading day in order to ensure loss realization. The firm implemented other control mechanisms including an emphasis on price control. They implemented training sessions that often stressed the dangers of holding losses too long. For example, the firm cites in their training manual that a trader’s inability to take a loss is the number one reason why traders fail. And they employed a trading manager who closely monitored trading activity throughout the day. The firm even hired an on-site psychologist who was readily available to meet with traders.

Despite all of these control measures, traders still appear to have difficulty coming to terms with their losses. We find that, on average, traders hold their losing trades significantly longer than their winning trades, which is consistent with the behavior underlying the disposition effect (see Shefrin and Statman, 1985). These longer holding times coincide with lower performance. While prior studies document that professional traders have a tendency to hold their losing trades longer than their winning trades (see, for example, Locke and Mann (2005) and Garvey and Murphy (2004)), the professional traders observed in prior studies were not required to close out of all of their positions by a predetermined time.5 In our setting, traders are forced to exit their positions by a predetermined time (i.e. the end of the trading day) and our main focus is on how traders holding times and performance vary across the day leading up to the inventory liquidation deadline.

We find that the difference between losing and winning round-trip holding times systematically rises throughout the day and that it rises to its highest level just prior to the inventory liquidation deadline. Moreover, trading performance significantly declines as the liquidation deadline draws near. Our sample traders often have difficulty realizing certain losses and they have a tendency to hold onto them until the very last moment. While the firm’s efforts do not statistically eliminate a trader’s tendency to hold losing trades longer than winning trades, they clearly do have an influence on trader behavior.

Inventory liquidation requirements ensure losses get realized, but firms (traders) also rely on price control mechanisms to do the job. While trade price is often heavily controlled in institutional trading settings, trade size usually is not. Institutional market participants trade in large trade sizes and their ability to execute these large trade sizes in their entirety is often driven by market conditions. Thus, professional traders need flexibility with respect to trade size. While we find that traders adhere to a highly disciplined approach with respect to their exit prices, trade size considerably varies and traders let their losses run longer on larger size trades. Consequently, they are more unprofitable when they trade in larger trade sizes.

Institutional Risk Control

Institutional Risk Control

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