Go Slow to Avoid Market Crashes

Women Leading Research: Yajun Wang

SMITH BRAIN TRUST – Wall Street traders make the most money when they do their best to stay under the radar of other traders by making their trades slow and steady. This strategy also keeps the market from crashing, according to new research from the University of Maryland’s Robert H. Smith School of Business.

Yajun Wang, assistant professor of finance, and Albert “Pete” Kyle, the Charles E. Smith Chair Professor of Finance, along with Anna Obizhaeva of Moscow’s New Economic School, wanted to pinpoint the best trading strategies to achieve equilibrium in the market. They determined that gradual movement toward a target inventory is the optimal strategy.

Traders, trying to make the most money on their transactions, typically spread their buying and selling out over a period of hours, days or weeks to stay under the radar of other traders. Traders assume their counterparts are also taking this slow-and-steady approach. But most are so confident that they have better information that they make price adjustments accordingly while continuing to trade.

The authors explain that a trader’s target inventory changes based on a stock’s price and the information he or she has about the stock. If the price falls, a trader can up his target because he can buy it more cheaply. Traders determine how fast to buy or sell based on how far the price is from what they think the asset is worth.

They point to Warren Buffet as the most obvious example of this mentality, buying the same stock for very long periods of time – sometimes months or even years – to avoid moving the price too much.

Problems such as flash crashes occur when traders do not play by these rules.

The research explains that stock prices are set by how much traders have bought in the past, affecting the price through permanent price impact. But the price is also a function of the rate at which traders are buying currently. Buying a lot today will push the price higher today, but if traders stop buying at the end of today and don’t buy tomorrow, the stock will fall back down and probably open lower the next day, called temporary price impact.

Read more: Smooth Trading with Overconfidence and Market Power.

Yajun Wang is an assistant finance professor at the University of Maryland's Robert H. Smith School of Business.

Research interests: Theoretical market microstructure and its links with asset pricing. Market microstructure is a field of finance which studies structure and design of different financial markets, price formation and price discovery, transaction costs, information and disclosure, as well as market maker and investor behavior. This field is important to government regulators who are concerned with the orderly functioning of the financial markets. Wang's work in this area contributes to the understanding of how market makers optimally make offsetting trades in the presence of asymmetric information and inventory risk and its impact on asset pricing; the optimal speed of trading by large asset managers who seek out risks to exploit private information about individual stocks and how the interactions among asset managers affect market stability and liquidity; and the effects of market frictions such as margin requirements, short-sale constraints, information asymmetry, transaction costs, and imperfect competition on asset prices, market volatility, market illiquidity, and social welfare.

Selected accomplishments: Work published in the Review of Economic Studies, the Journal of Economic Theory, Management Science, and Review of Finance.

About this series: The Smith School faculty is celebrating Women’s History Month 2018 in partnership with ADVANCE, an initiative to transform the University of Maryland by investing in a culture of inclusive excellence. Daily faculty spotlights support activities from the school’s Office of Diversity Initiatives, starting with the seventh annual Women Leading Women forum on March 1, 2018.

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Photo illustration credit: Danny de Bruyne