THE SOURCE OF LIQUIDITY

If all information had the same impact on all investors, there would be no liquidity.

When they received information, all investors would be executing the same

trade, trying to get the same price. However, investors are not homogeneous.

Some traders must trade and generate profits every day. Some are trading to

meet liabilities that will not be realized until years in the future. Some are highly

leveraged. Some are highly capitalized. In fact, the importance of information

can be considered largely dependent on the investment horizon of the investor.

Take a typical day trader who has an investment horizon of five minutes and

is currently long in the market. The average five-minute price change in 1992

was — .000284 percent, with a standard deviation of 0.05976 percent. If, for

technical reasons, a six standard deviation drop occurred for a five-minute

horizon, or .5 percent, our day trader could be wiped out if the fall continued.

However an institutional trader—a pension fund, for example—with a

weekly trading horizon, would probably consider that drop a buying opportunity

because weekly returns over the past ten years have averaged 0.22 percent

with a standard deviation 2.37 percent

In addition, the technical drop has

not changed the outlook of the weekly trader, who looks at either longer technical

or fundamental information.

Thus, the day trader's six-sigma event is a

0.15-sigma event to the weekly trader, or no big deal. The weekly trader steps

in, buys, and creates liquidity. This liquidity, in turn, stabilizes the market.

**All of the investors trading in the market simultaneously have different investment**

horizons. We can also say that the information that is important at

each investment horizon is different. Thus, the source of liquidity is investors

with different investment horizons, different information sets, and consequently,

different concepts of "fair price." Edgar Peters

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