Advanced Stock Market Trading - Level 2_2. Identifying Institutional Tactics and Coping with Them

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.