Are Professional Traders Too Slow to Realize Their Losses?

Data on a U.S. proprietary stock-trading team provide evidence of the tendency of traders to hold on to their losers too long and sell their winners too soon—that is, the “disposition effect.” The group of traders studied earned more than $1.4 million in intraday trading profits, but they realized their winning trades at a much faster rate than their losing trades. This tendency lowered their profitability. When the traders limited their risk exposure by trading in small share sizes, in low-priced stocks, or during periods of low volatility, the discrepancy between losing and winning holding times rose. An analysis of intraday prices suggests that traders could increase trading profits by holding winners longer and selling losers sooner. The behavioral finance theory that predicts individuals will hold their losing investments too long and sell their winning investments too soon is known as the “disposition effect.” Past research has demonstrated this tendency for individual investors, but we used a unique dataset to test whether highly and consistently profitable professional stock traders are susceptible to the same behavioral tendency. The extent to which professional stock traders suffer from the disposition effect has implications not only for the traders' profitability but also, because of these professionals' trading frequency and large block trades, for the price discovery process for active stocks.The 15-member trading team we studied generated more than $1.4 million in intraday trading profits over a 68-day trading period in a downward-trending market. But we show that these professional traders held their losing trades much longer than their winning trades. On average, losers were held for 268 seconds with an absolute price change and trading profit of, respectively, $0.10 and $100.46. Winning trades, on average, were held for 166 seconds with an average absolute price change and trading profit of $0.09 and $85.43. The traders were profitable because they completed more winning trades than losing trades overall.The traders minimized their loss exposure by trading few shares, trading low-priced stocks, or trading during times of low-market activity, but as far as holding losers too long and selling winners too quickly, they exhibited risky behavior. We considered intraday prices and the market trend before and after traders realized their open positions. When traders realized a profitable roundtrip, the price continued to increase for a long position and continued to decrease for a short position. When traders realized an unprofitable roundtrip, they could have lessened the loss if they had sold their long positions and covered their short positions sooner.These findings have implications not only for proprietary traders but also for other practitioners. For instance, portfolio managers who suffer from the disposition effect reduce investor returns. As is the case with proprietary traders, portfolio managers are generally considered to have a high level of financial sophistication, they trade the capital of others, and their actions are monitored by their employers. Our findings imply that a fund manager might outperform a standardized benchmark and receive a performance bonus but still produce returns that could have been higher in the absence of the costly disposition effect. Moreover, long-term investors may suffer from the disposition effect as much as the highly skilled traders we studied. In addition, because active traders affect market prices, those who suffer from the disposition effect are affecting all market participants. For instance, these professional traders accounted for nearly 2 percent of the share volume of Dell and WorldCom over our sample period. The tendency of these traders to refrain from selling losers could have slowed the rate at which negative news about these two companies was translated into prices. The sluggish response of other traders trading on the same signals could have slowed this rate even more.