nr 072 - Correlated Trading and Returns

DNB Working Papers
Date 23 December 2005

Retail clients at a major German discount broker trade in tandem – they tend to be on the same side of the market in a given stock during a given day, week, month, and quarter. Neither aggregate liquidity effects nor short sale constraints fully explain this behavior. The systematic execution of limit orders, coordinated through price movements or the correlated trading of other investors who pick retail limit orders, do not fully explain the observed comovement either. Rather, tandem trading appears to be mostly due to investors placing similar speculative bets. Correlated speculative trades perturb markets enough to make returns predictable over a short horizon. Correlated limit orders also predict subsequent returns, but for a different reason: limit order traders are compensated for accommodating other traders’ temporary liquidity demands. KEYWORDS: Retail investor trading, speculative trading, limit orders. JEL codes: G11, G12