Mechanics of Sales and Trading

Can unethical traders cheat inefficient markets? Isn't that inherently unfair as well as unstable?

I just returned from an interactive demo of the Finance Lab at the Rotman School of Management at the University of Toronto. In a class room with about 40 people, we were all engaged in trading two stocks on a fictitious market. It was everyone's first time on the software as we started the market simulation. It was my first time using this type of software and it was absolutely exhilarating!

[Recap] For those of you not familiar with how a stock market works, for any given stock, there is a list of bids and asks. Bids are prices which people are willing to pay to buy the stock, asks are prices people are willing to sell the stock. The highest bid and the lowest ask is the current spread. As transactions occur on either side at "market value", the highest bids and lowest asks are picked off. The only way these lists increase is when people put in "limit" orders (orders that explicitly say "buy or sell at this price only"). If there is too much buying, the stock price goes up dramatically. Conversely for selling.

Round 1: Unreasonable Profits As my partner and I started the simulation, it was clear most of the people in the room didn't really know what was going on. Their buy and sell strategies were essentially random. However, as I watched the monitors, I could quickly see that one of the stocks ("TAME") was quickly running out of asks (the number of requested transactions was low) and I spotted an opportunity to make an unreasonable (and highly illegal) profit. People wanted to participate in the market, weren't familiar with short selling, so the only actions they knew to do was to "buy". This stock was quickly becoming overbought.

Assuming that *someone* wasn't paying attention, I could put in an outrageous ask price (the stock was selling at ~$25) at around $500 and deliberately clear out all the remaining ask orders. That meant that if I was fast enough I could control the market price and the next time someone foolishly bought TAME at market price, I would sell my stock for at 20x (2000%). So we did it. And it worked. Some poor trader (or possibly a few poor traders) got killed, buying a $25 stock at $500. We were arbitraging carelessness. We quickly created and popped a bubble.

We had enough money to buy out the competition and manipulate the stock price (both highly unethical as well as highly illegal). We closed out with a return of 26% when the average was about 1%. An astronomically good return for a year of investing, let alone 5 minutes of trading.

Round 2: Good Profits After getting some more instruction, everyone in the room was given instructions to trade using only limit orders. This made it impossible to perform the same "trick" so we participated and looked for tighter spreads with more volume.

We closed out with a return of about 12% which was still in the top two thirds.

Round 3: Average By the time we got to the last round, the rest of the class had caught up and it was difficult for anyone to gain an informational (or strategic) advantage over anyone else. Our market was incredibly crowded (trading only two securities) and the only way to maximize profit was to do spread trading and rely on the computer player (designed to simulate relatively random decisions) to make mistakes and capitalize on them as well as take commissions from simulated "institutional" buyers. But in this case, no one had any advantage over anyone else.

The final scores were a relatively tight distribution with us still slightly above average (essentially random results - with everyone making gains due to the "rising tide" - computer simulated money entering the market).

Lesson: I think a lesson here is that efficient and competitive markets are the best markets. While that may be an obvious observation for most academics and intuitively clever people, it was certainly another matter all together to experience theory in practice in a live simulation. As it turns out:

1. The more aware you are of your surroundings, the less likely you are to make careless mistakes (like buying a $25 dollar stock at a "market" price of $500)
2. Our (illegal and unethical) strategy should have back fired if people were paying attention (as they did in rounds 2 and 3) by stepping in when the price got too high and keeping it deflated (someone could have "under cut" our outrageous ask price, but posting their own ask price at a more reasonable (but still highly profitable) $30 (and this process can and should occur iteratively until the stock reaches its intrinsic value on both sides of the bid / ask spread).
   
3. The more competitive a market is, the harder it is to make abnormal profits regardless of strategies used.
4. People in sales and trading can't trade by "committee" or even pairs, although my partner and I got along really well, those split seconds where we seeked each other's approval for executing trades killed us a lot. I think that each person needs to live and die by their own sword in sales and trading because the trading windows of opportunity you are operating in are so narrow. This is in stark contrast to what should happen in a fund, where associates need to work with portfolio managers in valuations and analysis.
5. Scalpers make money off the the bid / ask spread and tend to do better with stable prices. People who have specific positions will do better with more volatility if they can anticipate the movement of the price.