Lesson 2: Identifying Institutional Tactics and Coping with Them Trading securities can be as simple as pressing the buy or sell button on an electronic trading account. A more sophisticated trader may opt for a more complex trade by setting the limit price on a block trade that is parsed over many brokers and traded over several days. The differences lie in the type of trader (retail or institutional), the level of sophistication, and the speed with which the transaction is required. There are two basic types of traders: retail and institutional. Retail traders, often referred to as individual traders, buy or sell securities for personal accounts. Institutional traders buy and sell securities for accounts they manage for a group or institution. Pension funds, mutual fund families, insurance companies and exchange-traded funds (ETFs) are common institutional traders. #What is an Institutional Investor? An institutional investor is a nonbank person or organization that trades securities in large enough share quantities or dollar amounts that it qualifies for preferential treatment and lower commissions. An institutional investor is an organization that invests on behalf of its members. Institutional investors face fewer protective regulations because it is assumed they are more knowledgeable and better able to protect themselves. There are generally six types of institutional investors: endowment funds, commercial banks, mutual funds, hedge funds, pension funds and insurance companies. Institutional investors are entities that pool together funds on behalf of others and invest those funds in a variety of different financial instruments and asset classes. Institutional investors control a significant amount of all financial assets in the United States and exert considerable influence in all markets. #Resources of Institutional Investors Institutional investors have the resources and specialized knowledge for extensively researching a variety of investment options not open to retail investors. Because institutions are the largest force behind supply and demand in securities markets, they perform the majority of trades on major exchanges and greatly influence the prices of securities. For this reason, retail investors often research institutional investors’ regulatory filings with the Securities and Exchange Commission (SEC) to determine which securities the retail investors should buy personally. Retail investors typically do not invest in the same securities as institutional investors to avoid paying higher prices for the securities. #Retail Investors vs. Institutional Investors Retail and institutional investors invest in bonds, options, futures contracts and stocks. However, because of the nature of the securities and/or the manner in which transactions occur, some markets are primarily for institutional investors rather than retail investors. Examples of such markets primarily for institutional investors include
the swaps and forward markets. Retail investors pay brokerage firm fees along with marketing and distribution costs for each trade. In contrast, institutional investors send trades through to exchanges independently or through intermediaries; they negotiate a fee for each transaction and avoid paying marketing and distribution costs. Retail investors buy and sell stocks in round lots of 100 shares or more; institutional investors buy and sell in block trades of 10,000 shares or more. Because of the larger trade volumes, institutional investors avoid buying stocks of smaller companies and acquiring a high percentage of company ownership. The investment cannot be sold when desired for little or no loss in value and performing such an act may violate securities laws. For example, mutual funds, closed-end funds and exchange-traded funds (ETFs) registered as diversified funds are restricted as to the percentage of a company’s voting securities the funds can own. Conversely, retail investors find small companies’ lower stock prices attractive; they can invest more diversified portfolios in smaller price ranges than larger ones. Advantages Institutional investors are generally considered to be more proficient at investing due to the assumed professional nature of operations and greater access to companies and managements because of size. These advantages may have eroded over the years as information has become more transparent and accessible, and regulation has limited the amount and method of disclosure by public companies. #Types of Institutional Investors Institutional investors include public and private pension funds, insurance companies, savings institutions, closed- and open-end investment companies, and foundations. Pension Funds Pension funds are the largest part of the institutional investment community and control over $10 trillion, or approximately 40% of all professionally managed assets. Pension funds receive payments from individuals and sponsors, either public or private, and promise to pay a retirement benefit in the future to the beneficiaries of the fund. The large pension fund in the United States, California Public Employees' Retirement System (CalPERS), reported total assets of $239 billion at as of 2011. Although pension funds have significant risk and liquidity constraints, they are often able to allocate a small portion of their portfolios to investments which are not easily accessible to retail investors such as private equity and hedge funds. Most pension fund operational requirements are discussed in the Employee Retirement Income Security Act (ERISA) passed in 1974. This law established the accountability of the fiduciaries of pension funds and set minimum standards on disclosure, funding, vesting and other important components of these funds. Investment Companies
Investment companies are the second largest institutional investment class and provide professional services to banks and individuals looking to invest their funds. Most investment companies are either closed- or open-end mutual funds, with open end funds continually issuing new shares as it receives funds from investors. Closed end funds issue a fixed number of shares and typically trade on an exchange. Open end funds have the majority of assets within this group and have experienced rapid growth over the last few decades as investing in the equity market became more popular. In 1980, investment companies comprised only 2.9% of all institutional assets, but this share more than tripled to 9.4% by 1990 and reached 28.4% by the end of 2009. However, with the rapid growth of ETFs many investors are now turning away from mutual funds. The Massachusetts Investors Trust came into existence in the 1920s and is generally recognized as the first open-end mutual fund to operate in the United States. Others quickly followed and by 1929 there were 19 more open-end mutual funds and nearly 700 closed-end funds in the United States. Investment companies are regulated primarily under the Investment Company Act of 1940, and also come under other securities laws in force in the United States. Insurance Companies Insurance companies are also part of the institutional investment community and controlled almost the same amount of funds as investment firms. These organizations, which include property and casualty insurers and life insurance companies, take in premiums to protect policy holders from various types of risk. The premiums are then invested by the insurance companies to provide a source of future claims and a profit. Savings Institutions Savings institutions control over $1 trillion in assets. These organizations have seen a huge drop in assets over the last generation, with the percentage of assets held by savings institutions declining from 32.6% in 1980 to only 4.9% in 2009. Foundations Foundations are the smallest institutional investor as they are typically funded for pure altruistic purposes. These organizations are typically created by wealthy families or companies and are dedicated to a specific public purpose. The largest foundation in the United States is the Bill and Melinda Gates Foundation, which held $36.7 billion in assets at the end of 2010. Foundations are usually created for the purpose of improving the quality of public services such as accessibility to education funding, healthcare and research grants. #Institutional Tactics Institutional traders use dirty tactics in the stock market that are so bad, they should be illegal. Learn how these apex predators work so you can avoid being their prey. 1. The Phone Number to All Market Makers
Let’s say an Institutional trader has to dump 100,000 shares in a stock. He has so many shares that if he sold the stock the way we do, he’d have a bunch of partial order fills all the way down. Short sellers would make a killing. So, what an Institutional trader will do is prevent the short sellers from cashing in by making a call to a number of market maker buddies of his. He might call five or six different market makers and sell them 20,000 apiece, each at varying prices. 2. Back Door Deals with Market Makers What happens if an Institutional trader has to dump 100,000 shares in a stock that only trades a total of 20,000 shares a day? Once again, they can call their market maker buddies and work a back-door deal that screws short sellers out of their profits. A market maker will set a specific price to buy all the shares. the Institution wants to sell at $1 or $2 in the hole meaning below where the stock is actually trading for average stock traders like you and me. The idea is to take the initial price, which is below where it’s trading, and get out of it for the Institutional trader. And he’s not taking the risk of selling 10,000 shares down a point, but not seeing a bid for the next 10,000 shares that he has to sell until three points down. So, the first sale is your best sale. And if you have to get out of a block, that’s the way to do it. This totally screws the short sellers. It also pays out to the market makers who get to sell the stock to average traders like you and me for $1 to $2 more than what they bought it for from the Institutional trader. It also means that average traders are paying a $1 to $2 more per share than the Institution trader and market makers know it’s actually worth. 3. They Can See All Limit Orders Institutional traders can see all the limit orders for any stock. You and I can’t. This means that they know exactly how many buy orders are waiting to be automatically executed above a certain resistance level or how many sell orders are waiting to be automatically executed below a certain support level. In other words, you and I set our resistance and support levels based on past price movement. Institutional traders set their resistance and support levels on actual market demand, knowing exactly how many shares will be bought or sold at various price levels. This means that Institutional traders have all kinds of advantages over us average traders. For example, Institutional traders engage in what is called “running the stops”. False breakouts happen when Institutional traders organize hunting parties to run stops. For example, when a stock is slightly below its resistance at $30, the buy limit orders come flowing in near $28.50. The institutions calculate the liquidity ratio which measures how much the stock will go up if all buy limit orders are executed at $28.50. They calculate that the stock will run to $31 if all the buy limit orders at $28.50 are executed. They short the stock at $30 to push it down to $28.50. At $28.50 they cover their short position and go long as the wave of buy orders are automatically executed pushing the stock up to $31. If greedy traders start piling in, the institutional trader will stay long the trade. As soon as the buy orders start drying up, they sell short and the price falls back below $30. That’s when your chart shows a false upside breakout. Sometimes, Institutional traders will clear out players from the table by “running the stops” all the way down. Case in point is what happened in Dendreon (DNDN) in
April of 2009. Institutional traders began selling within the space of a few minutes. Having risen to nearly $25 by about 1 PM, trading was halted in the stock at 1:27 PM, with it now trading at $11.81! The next day, the stock shot straight back up to its former levels. What happened is that Institutional traders saw a beautiful set up in the stop loss orders where they could sell 10% of their position on the open market which would trigger another 30% drop by way of stop loss orders being automatically executed. Then after market close, they called their market maker buddies and arranged a very large buy order to be executed before market open the next day which gap opened trading. The end result was that rather than just buy more stock from shareholders at a higher price, Institutional traders cheated stock holders out of their gains by forcing the stock to drop more than 50%, then buying up all the shares from those panicked sellers. Today the stock trades for more than $36 a share with Institutional traders making more than 200% from this “running the stops” move. 4. Squawk Box or Black Box So why do Institutional traders quit their day jobs, trade for a living at home, then wash out and have to go back to work as an Institutional trader? Why couldn’t these guys take the lessons they learned in their day jobs home with them? Well, other than not having access to stop orders, there’s another dark truth. Or should I say black truth. Rumor has it that ex-CIA economists offer a service to Institutional traders that costs $15 million dollars a year to have. It’s a box that plays live audio from the exchange floor that provides informative audio quotes which include bids/offers, quantity and activity of major brokerage houses, local floor traders and others. This audio is several minutes ahead of “real time” stock data feeds. Rumor also has it that these guys travel to various companies and interview CEOs and even attend public stockholders’ meetings and earnings announcements. They use CIA training tactics to tell if someone is lying. When Institutional traders don’t have these advantages trading from home, they become ordinary losers just like the rest of us. #Conclusion Institutional investors remain an important part of the investment world despite a flat share of all financial assets over the last decade, and still have considerable impact on all markets and asset classes.