The Effects of Institutional Risk Control on Trader Behavior

Abstract

We examine how institutional risk control mechanisms influence proprietary stock trader behavior. When traders are forced to liquidate their inventory at a pre-designated time, they often hold onto their losing trades until the very last moment. We find that the difference between losing and winning round-trip holding times systematically widens leading up to an inventory liquidation deadline and trading becomes less driven by trading practices and more induced by the firm's control mechanism as the deadline draws near. When trade price is heavily controlled yet trade size isn't, we find that the difference between losing and winning round-trip holding times systematically widens with trade size. This result suggests traders increase their risk-taking in areas where institutional control mechanisms are weaker. Our findings highlight the difficult balancing act firms face with getting market professionals to realize their losses without impeding their trading strategies.