Most people tend to equate traders with short term punters who are in the market purely to make money. Like investors, traders too are in the market to make money but remember there is a method and a larger purpose to trading. You will be surprised to know that markets cannot function without the active participation of traders. Here are 5 key roles that traders play in the equity, F&O and commodity markets and why there are critical
Reduce risk in the market through high volumes
Imagine that you are trying to sell 100 shares of a stock and you find that there are no buyers. That must have surely happened to you with small and mid-cap stocks but you may have hardly faced the problem with large cap stocks. For that you need to thank the traders in the market. Traders are in the market for short term to medium term profits .As a result they are agnostic in their trading strategies. That means; at higher levels these traders can be sellers and the same traders can be buyers at lower levels. It is this two-way approach of traders that actually makes the market liquid, increases the volumes in the market and ensures that your transactions get executed with minimal execution risk. These actions of traders substantially reduce the risk of participation in the markets.
Help in interpreting decision points
This is a very important role that trades play in the markets. During the day there are a number of triggers. There could be the Fed minutes, the RBI policy, quarterly results coming out, companies facing debt repayment problems, promotes pledging shares and even announcements pertaining to corporate actions. It is impossible for an investor to sit and evaluate these factors on an individual basis. Most long term investors are not exactly keen on the shorter term trends. By trading in and out of the markets on the basis of news flows and market flows, the traders are instrumental in disseminating intelligence about a stock. This becomes a very critical input point for the other traders and investors in the market.
Traders assist keep the trading spreads in control
This benefit may not obvious to you unless you actually get down and trade in the market. Imagine that you are trying to sell your shares but the seller is nearly four rupees away from your buying price. By adhering to the buyer’s request you will incur a loss of Rs.4. This problem can be overcome if the bid-ask spreads are finer and narrower. That is a job that traders do to perfection. If they find the spreads too wide, then traders participate in intermediate spreads inducing buyers and sellers to settle at a profitable level. In the process the trader also makes a spread but also reduces the overall risk in the market by tightening the bid-ask spreads on the stock.
Traders ensure that inefficiencies in the market are traded away
This is a very important role that traders play. Let us say the same stock is quoting at a spread-gap of 1% between the BSE and the NSE. A smart trader will spot this arbitrage opportunity and buy the same stocks in the exchange where it is priced lower and sell in the exchange it is priced higher. This also happens in case of stocks where the cash/futures arbitrage spread is too wide. For example if the stock of RIL is quoting at Rs.900 and the future is quoting at Rs.918, then it translates into an arbitrage spread of 2% per month. Traders and arbitrageurs will immediately buy RIL in the spot market and sell it in the futures market till the time the spread comes down to more realistic levels. So when you trade expecting a mean reversal, it is the action of traders that brings about the mean reversion by trading away the inefficiencies.
Short sellers can prevent acute market crashes
Most people fear stock market crashes because it results in closure of positions and massive losses. Normally, speculators and short sellers are blamed for market crashes but ironically these short sellers can actually prevent the market from crashing sharply. Here is how! When traders are negative on the market, they will sell the stock or the future short. While it puts pressure on the market, it is not a free fall as the delivery positions are not liquidated. Secondly, when short sellers sell the stock at higher levels, they also come to buy back the stock at lower levels. This short covering helps in stabilizing the market limiting your losses in the process. However, in the absence of short sell traders, markets can go into a free fall with larger implications for investor wealth.
Contrary to what most people believe, traders have a very important role to play in markets. In fact, markets will not be as robust and efficient that they are today had it not been for the traders. They not only provide liquidity but also ensure that the short term cues on the macroeconomic and micro front are factored into prices. After all, that is what a healthy market is all about!