Title: Informed trading or liquidity trading: a theoretical formulation

Authors: Rebecca Abraham

Addresses: Huizenga College of Business, Nova Southeastern University, 3301 College Ave, Fort Lauderdale, Fl 33319, USA

Abstract: This paper provides theoretical formulations of informed trading contrasted with liquidity trading. Informed trading occurs when traders flock to purchase or sell securities, based upon private information. In contrast, liquidity traders purchase or sell securities for their own inventory. Informed traders purchase in large volume over very short periods of time, with a definite direction of price movement. Liquidity trading consists of unlimited market entry of traders, reducing profit per trader, along with a long time period of investment in which the direction of price movement is uncertain, diminishing gains. This paper presents optimal trade prices for informed traders prior to stock mergers, whereupon traders have been observed short selling the acquirer stock, using the proceeds to purchase target stock, or to purchase put options. A capital structure arbitrage strategy is used for liquidity traders, with the trader purchasing or selling bonds at trade prices influenced by the market maker's prices. Proceeds from this strategy may be used to purchase equities.

Keywords: informed trading; intraday trading; short selling; liquidity trading.

DOI: 10.1504/IJFMD.2021.113866

International Journal of Financial Markets and Derivatives, 2021 Vol.8 No.1, pp.1 - 22

Received: 06 May 2020
Accepted: 21 Sep 2020
Published online: 31 Mar 2021 *

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