Are Retail Traders Compensated for Providing Liquidity?

48 Pages Posted: 23 Jun 2014 Last revised: 14 Oct 2015

Jean-Noel Barrot

Massachusetts Institute of Technology (MIT)

Ron Kaniel

University of Rochester - Simon Business School; CEPR

David Alexandre Sraer

University of California, Berkeley; Princeton University

Multiple version iconThere are 3 versions of this paper

Date Written: June 20, 2014

Abstract

This paper examines the extent to which individual investors provide liquidity to the stock market, and whether they are compensated for doing so. We show that the ability of aggregate retail order imbalances, contrarian in nature, to predict short-term future returns is signifi cantly enhanced during times of market stress, when market liquidity provisions decline. While a weekly rebalanced portfolio long in stocks purchased and short in stocks sold by retail investors delivers 19% annualized excess returns over a four factor model from 2002 to 2010, it delivers up to 40% annualized returns in periods of high uncertainty. Despite this high aggregate performance, individual investors do not reap the rewards from liquidity provision because (i) they experience a negative return on the day of their trade, and (ii) they reverse their trades long after the excess returns from liquidity provision are dissipated. During the fi nancial crisis, French active retail stock traders stepped up to the plate, increased stock holdings, and provided liquidity. In contrast, mutual fund investors fled from delegation by selling their mutual funds.

Keywords: retail investor behavior, return predictability, liquidity provision

JEL Classification: G14

Suggested Citation

Barrot, Jean-Noel and Kaniel, Ron and Sraer, David Alexandre, Are Retail Traders Compensated for Providing Liquidity? (June 20, 2014). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2457051 or http://dx.doi.org/10.2139/ssrn.2457051

Jean-Noel Barrot (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Ron Kaniel

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

David Alexandre Sraer

University of California, Berkeley ( email )

310 Barrows Hall
Berkeley, CA 94720
United States

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544
United States

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