Types of Traders
Traders can be characterized by their motivation to trade.
Information Motivated
Information motivated traders are those who believe they have information whose value declines over time (as it becomes recognized by other market participants.) These types of traders seek speedy execution, and are less sensitive to the price at the time of trade. If successful over time, information traders will want to hide their identity so that potential trading counterparties will not suspect their motive and drive the security price away from them.
Liquidity traders are likely to use market orders, and often rely on market makers to fill the other side of their trades. They are also prone to trade in large blocks so as to maximize the value of their information.
Value Motivated
Value motivated traders use judgment based on careful research to identify the proper price at which to buy a stock. They will only trade if the price is at or below their perception of true value. They often use limit orders and patiently wait for the stock to reach their price. Trading can occur infrequently, but over time they may gradually accumulate or distribute large positions relative to their total portfolio.
Liquidity Motivated
Liquidity motivated traders transact because they need to. Perhaps a better opportunity has come along, or they may simply need to raise cash for some reason. As such, they are not particularly sensitive either to valuation or to unique information.
Since liquidity motivated traders are natural counterparties to value and information traders, their existence in the market has value. Liquidity traders can try to recognize the value they add by offering orders inside the spread as a way of attracting other traders to them.
Passive Traders
Index managers have to trade in order to rebalance their positions to the benchmark whenever there is a change in benchmark constituency. Sometimes (for example, if a company being added is larger than the one it replaces) this will require substantial liquidity, as the trade can have flow-through effects to many other stock weights in the index. Passive managers are also very sensitive to trading costs, as they want to limit their tracking error relative to a benchmark that does not incur such costs.
Passive traders often resemble dealers by providing the bid (or ask, as appropriate) on their stocks of interest and allowing the opposing party to decide when to trade. This allows them to exchange their lack of urgency for a lower execution cost.
For more information, see all articles on: Active Management, Investing in Stocks, Portfolio Management, Trading Execution See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
