Correlated Trading and Returns Daniel Dorn (Drexel U) Gur Huberman (Columbia U) Paul Sengmueller (U of Amsterdam)

37,000 Clients of a Large German Discount Broker in 1998-2000 To what extent are they on the same side of the market? Stock returns when clients are on the same side of the market? Stock returns subsequent to clients being on the same side of the market? Net trade = 0! Correlation of returns & trading aims at ability to predict market, or even exert a pressure on prices.

Lakonishok, Shleifer, Vishny The impact of institutional trading on stock prices (JFE, 1992) Data: quarterly frequency. Conclusion: not much. LSV herding measure:

To what extent are they on the same side of the market? Bottom trading quartiles Top trading quartile Daily 3.5% 5.3% Weekly 3.6% 5.6% Monthly 3.8% 6.9% Quarterly 6.6% 7.9% For each instance, must have at least 2 active traders Median LSV measure

Stock returns when clients are on the same side of the market? When clients buy, returns positive When clients sell, returns negative.

Stock returns after clients are on the same side of the market? After clients have bought, returns positive After clients have sold, returns negative.

Importance of limit orders If price goes up on a day Mainly sell limit orders will be executed Two effects: Exaggeration of correlated trading Negative correlation between return & direction of trading.

Half the trades are SPECULATIVE LSV Measures Non-speculative market orders Speculative Daily LSV 5.8% 5.0% Weekly LSV 5.7% 6.0% Monthly LSV 4.5% 7.6% Quarterly LSV 4.8% 9.3% Difference becomes important with lower frequency

Persistence of buyers ratios Weeks relative to portfolio formation -1 0 (formation) +1 PF1 (sell) 0.41 0.10 0.37 PF2 0.46 0.43 0.44 PF3 (buy) 0.52 0.77 0.50 PF3-PF1 0.17 0.67 0.12 Even stronger numbers at the daily frequency

Weeks relative to portfolio formation Weekly returns of portfolios based on comovements of speculative trades Weeks relative to portfolio formation -1 +1 PF1 (Brokerage sell) 0.15 -1.16 0.02 PF2 0.83 0.19 PF3 (Brokerage buy) 2.24 3.52 0.64 PF3-PF1 2.08 4.68 0.61 N 122 Equally weighted, % returns.

Weeks relative to portfolio formation Weekly returns of portfolios based on comovements of NON-speculative trades Weeks relative to portfolio formation -1 +1 PF1 (Brokerage sell) 1.76 0.63 0.21 PF2 1.11 1.21 0.04 PF3 (Brokerage buy) 0.97 1.37 0.17 PF3-PF1 -0.79 0.75 -0.04 N 122 Note the differences in returns vs. the previous slide

Correlated trading & returns At the weekly frequency, Trading of these people is positively correlated with returns. Speculative trading of these people leads subsequent returns.

Why contemporaneous correlation? Same signals that cause price change also cause these people to trade in the same direction. These people’s trades push prices.

Why speculative trading leads returns? Speculators are good at predicting price changes. These people’s trades push prices. These people’s trades are persistent.