On the Nature of Trading

Abstract

Two types of traders, market makers and speculators, establish their positions and manage their risk exposure differently, but balance sheets are insufficient to let us determine whether a trader is a market maker or a speculator. We want to understand and verify trader behavior, because leveraged trading firms, and individual traders, typically have incentives to mask their risk-taking activities. Without proper monitoring, traders can substitute risky speculation for less risky market-making to reap potential payoffs. Trading records that describe the evolution of a position over time can help us identify the trading strategy pursued. And knowledge of the trading strategy is an aid to evaluate the contract compliance, risk exposure, and capital requirements of trading firms.