On the Nature of Trading: Do Speculators Leave Footprints?

Abstract

The paper describes how two types of traders, market makers and speculators, establish their positions and manage their risk exposure. We show that balance sheets are insufficient to determine whether a trader is a market maker or a speculator. On the other hand, trading records describing the evolution of a position over time can identify what trading strategy was pursued. Knowing the trading strategy helps to evaluate contract compliance, risk exposure, and capital requirements of trading firms. Understanding and verifying trader behavior is especially important because leveraged trading firms, and individual traders, have traditional incentives to mask their risk-taking activities. Without proper monitoring, traders can substitute risky speculation for less risky market making to reap potential payoffs.