How Large Traders Disguise Their Presence in the Stock Market

I received a note from BZB Trader after he had posted interesting information to his blog. He had collected data to better understand order flow and had observed two things:

1) Retail traders account for a small proportion of total volume;

2) Large traders are heavily using order execution software to break their large orders into small pieces.

I performed a very simple exercise and examined the first hour of trading in a popular stock, AAPL. There were almost 57,000 trades in the first hour alone.

By my calculation of how the trades were reported, roughly two-thirds of these trades were broken down into small pieces for execution. Over three-quarters of all first-hour trades were 100 shares. Of the small, 100-share trades, I estimate that about two-thirds were part of larger trades that were executed in pieces by specialized software.

In other words, if you were to simply look at trades and trade volume, you'd conclude that small traders were dominating the marketplace. The reality is, however, that large traders continue to hold sway, but have succeeded in disguising their presence.

For the trader interested in determining who is in the market and what they're doing, it is either necessary to re-aggregate the trade data by a conceptual reverse-engineering--a difficult, computationally-intensive endeavor not feasible for most traders--or it becomes necessary to make inferences on the basis of larger time units (1 minute data, etc.) that naturally aggregate the trades.

More on this latter strategy soon to come. Meanwhile, consider how the disaggregation of large trades increases trade volume on the stock exchanges, increases the bandwidth necessary to process market information, and potentially distorts such measures as NYSE TICK, Market Delta, and money flow.

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