Liquidity, overpricing, and the tactics of informed traders

In this paper we explore the profit-taking tactics employed by informed traders when there are informational asymmetries across investors. Our laboratory is Tradesports, which until 2015 operated a double auction exchange where participants traded binary options contracts. This venue is a close analog to stock markets and, because each contract’s value is unambiguously revealed, the joint hypothesis problem is mitigated. We demonstrate that when the ratio of noise traders to sophisticated traders is highest, shares are most overpriced. Data show that informed traders heavily target noise traders when liquidity is high, and in conducting profit-taking operations they prefer to short sell via small transactions and round lots. Results suggest that, even in the absence of liquidity constraints and certain costs and risks related to short selling, the relative complexity of short selling can itself lead to overpricing. © 2016, Springer Science+Business Media New York.