From the Psy-Fi blog:
Although behavioral psychology has helped explain some of the odder effects around investment there remain many sceptics. The reason for this isn’t hard to find, because if you start out assuming that peculiar features of investment markets are caused by rampant misbehavior then you’re quite likely to find evidence to support that assumption.
Some of this is down to irrational behavior, no doubt, but perhaps not in the way that the academics first thought. So, for instance, consider the use of the humble limit order. Used unwisely – which is to say, nearly always – it doesn’t just lose investors money but ruins the researchers’ results into the bargain. Just watch those behavioral biases crumble away.
Limit orders are pre-set limits at which stock is automatically bought, as it falls through the limit price, or sold, as it rises. Limits guarantee a maximum or minimum price, but not execution. And they’re very popular:“Limit order books (LOBs) are used to match buyers and sellers in more than half of the world's financial markets (Ro_su, 2009). Euronext; the Australian Securities Exchange; and the Helsinki, Hong Kong, Swiss, Tokyo, Toronto, and Vancouver Stock Exchanges all now operate as pure limit order markets (Luckock, 2001), and the New York Stock Exchange (NYSE); NASDAQ; and the London Stock Exchange (LSE) (Cont et al., 2010) all operate a bespoke hybrid limit order system”.Although limit orders provide protection of a sort for investors it also exposes them to the winner’s curse – the problem that by fixing the price they are willing to buy or sell at they can be picked off when their orders become mispriced – which will happen when new information hits the market. Of course, many limit orders will execute rapidly but us private investors are faced with the almighty power of the high frequency traders and, as Peter Hoffman hypothesises:“Fast traders (FTs) may revise their limit orders upon news arrivals and therefore avoid being ”picked off” (Copeland and Galai (1983)), but only if the next agent is a slow trader (ST). In this stylized environment, a world with only FTs is identical to a world with only STs because speed only matters in relative terms.”A Bigger Bezzle
The point of this preamble is that limit orders are important, and even relatively short-term “fill or kill” orders are exposed to these risks when individuals are trading against the light-speed limited algorithmic monsters of the high frequency traders (Trading At The Speed of Light). This is just another way in which private investors are taxed by the securities industry and one not even included in the analysis behind the 160 Billion Dollar Bezzle. As the paper above concludes, these practices are never favourable for smaller, slower investors.
Now, if we think through the impact of limit orders on investors it leads us into a curious conundrum. Consider a stock which, out of the blue, announces good news. The market reaction to this will be to push the price of the stock up, to reflect the new information yet, at some point, the rising price is going to start hitting limit orders, where preset sales are going to be triggered. Counterintuitively, investors will start to sell their winning firms....MORE