Counterparty - Explained
What is a CounterParty?
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Table of ContentsWhat is a Counterparty?What is Counterparty Risk?What are the Types of Counterparty in Financial Trading?What are Market Makers (MM)? What are Liquidity Traders?What are Technical Traders? What is are Momentum Traders?What are Arbitragers?Academic Research
What is a Counterparty?
A counterparty refers to the other party in a transaction. In layman terms, a counterparty is either a buyer or a seller, without which a transaction cannot take place. For a buyer who wants to purchase some items, the counterparty will be a seller who is willing to supply the buyer with his needs. Also, for a seller who is looking to sell off his inventory, the counterparty will be the buyer purchasing it.
What is Counterparty Risk?
In a transaction, there exists counterparty risk. This is defined as the risk or possibility that the counterparty will not fulfill their end of the bargain. To better mitigate this risks, transactions between counterparties are often fulfilled by clearing firms, especially in cases where the parties don't known each other.
What are the Types of Counterparty in Financial Trading?
Counterparties in a market trade can be categorized in different ways.
What are Retail counterparties?
Retail traders are usually non-professional and individual investors who engage in trading via retail brokers like Interactive Brokers or Charles Schwab. In most cases, these traders are attractive to other investors since they have a much more limited knowledge of how things really work in the market, have access to less sophisticated trading indicators and tools, and they're always ready to buy at the offer and sell at the bid.
What are Market Makers (MM)?
Market makers are usually the big game in the pool. They're more interested in keeping the market alive, although they tend to lock in profits from time to time. These traders have sophisticated tools and they're usually one of the leading factors in the direction of the market and what is offered on book. Market Makers usually get profits from ECN rebates and by providing liquidity. These traders also move the market for their own gains especially when there is a tendency of a capturable profit.
What are Liquidity Traders?
Liquidity traders are non market makers with low fees and they capture profits by adding liquidity to the market and collecting ECN credits. These traders are fairly respected in the market, but not as much as the market makers. They also tend to make capital gains by getting filled on the bid (offer) and then selling the offer at insiders price or at the existing market price.
What are Technical Traders?
Technical traders are the largest collection of traders as they draw a large audience from all sorts of market traders. These traders make use of charts levels, sometimes from indicators, trend patterns, or chart patterns. They're usually watchful and they're patient enough to wait for a perfect point of entry and exit in the market. Subsequently, one could say that they're the largest groups that determines market risks. In some conditions, liquidity traders and Market Makers can become technical traders, although not in the same way as retail traders. A market maker can make a false move in the market knowing fully well that a large amount of technical traders will fall victim to this deceit, thus churning large amounts of shares.
What is are Momentum Traders?
Momentum traders (usually called scalpers) are the fastest and most complex category of traders. They're intraday traders who can study charts for several days (with the intention of trading it for just one day). Dominantly, they're always on a lookout for quick movements that'll allow them jump in on take sharp profits within seconds or minutes. These traders make use of technical indicators as well as news events, volume spikes and price patterns. Some momentum traders are capable of placing up to hundreds of trades per day, and they'll only looking for small movements in their desired direction to exit the trade. Momentum traders are mostly disciplined, have perfect knowledge of risk and money management, and have perfect knowledge of entry and exit strategies.
What are Arbitragers?
Arbitrage means to look for exploit in the market and use it to ones advantage. This traders usually take the less risky route of trading by making use of multiple assets and trading statistical tools. They're always on the lookout for inefficiencies in markets of all sort. Arbitrage traders are usually wealthy individuals or entities with enormous buying powers, as they require a large buying power to benefit considerably from the little inefficiencies which they've identified. For instance, and arbitrage trader may get to spot a chance to make $.10 per share in a market. Buying 1000 units of such stock with $100,000 will only yield him a profit of approximately $100. Nobody wants to invest $100,000 to make just $100, and so, they'll tend to use a higher buying power to get profits. They could choose to purchase 100,000 units of such a stock to make a profit of $10,000 or even purchase up to 10 million units of such a stock and make a million dollars. The later is quite rare though, as they'll always careful not to expose the exploit before cashing out as much as possible.