Local trader profitability in futures markets: Liquidity and position taking profits

Abstract

This study examines the profitability of local traders on floor-traded futures markets. Using unique data from the period of floor trading on the Sydney Futures Exchange, local income is decomposed into liquidity and position-taking profit components. Locals on the trading floor are found to make significant positiontaking profits. Moreover, the ability of locals on the floor to derive position-taking profits is positively related to order-flow related information, and negatively related to the presence of exogenous information, local liquidity profits and the length of a locals inventory cycle. Accordingly, this paper characterizes locals as active informed traders.A number of prior studies have analyzed data for US futures markets and quantify total profits earned by local traders (e.g. Silber, 1984 has trade data for a single local trader). Further, some analysis of the profitability of local traders in US markets has taken place. For example, Kuserk and Locke (1996) compare profits of locals on days in which futures prices hit price limits to other days, while Fishman and Longstaff (1992) compare the profits of locals to other classes of trader. While most floor traded exchanges around the world and academic papers examining locals suggest that locals provide liquidity (see for example Kuserk, Locke, & Sarkar, 2000), there is no evidence that locals serve this function. Indeed, there are suggestions in the literature that they may have some sort of information advantage which allows them to predict and trade on order-flow related information (e.g. Silber, 1984). The profits earned by locals represent their reward for providing liquidity and/or trading on orderflow related information. Hence an analysis of the profits of locals can provide evidence on their economic role.This study decomposes the profits of local traders by comparing prices at which they trade to standing quoted bid and offer prices in a manner similar to Hasbrouck and Sofianos (1993). While data detailing the identity of local traders in US markets exists, these exchanges do not collect quote information (see Smith and Whaley, 1990). Unlike US futures markets, during the period of floor trading the Sydney Futures Exchange collected quote information as well as transaction data identifying the parties involved in trades for settlement purposes. This provides a unique opportunity for decomposing the profits of local traders into liquidity and profit-taking trades.The remainder of this study is organised as follows. Section 2 contains the literature review and hypothesis development. Section 3 outlines the data and methodology employed. Section 4 describes the results attained, while Section 5 contains conclusions and directions for future research.A dominant theme in the theoretical market maker and asymmetric information literature Glosten and Milgrom (1985), Admati and Pfleiderer (1988) is that market makers trade with two main types of counter-parties -informed and liquidity traders. This literature typically asserts that while market makers...

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