Trading against disorderly liquidation of a large position under asymmetric information and market impact

TL;DR

This paper analyzes how small investors with varying information levels optimally trade in markets affected by a large trader's disorderly liquidation, considering market impact and asymmetric information.

Contribution

It introduces a theoretical framework comparing optimal trading strategies of different investor types under asymmetric information and market impact during large position liquidations.

Findings

Informed investors better anticipate liquidation triggers.

Market impact significantly affects optimal trading strategies.

Numerical results illustrate the differences among investor types.

Abstract

We consider trading against a hedge fund or large trader that must liquidate a large position in a risky asset if the market price of the asset crosses a certain threshold. Liquidation occurs in a disorderly manner and negatively impacts the market price of the asset. We consider the perspective of small investors whose trades do not induce market impact and who possess different levels of information about the liquidation trigger mechanism and the market impact. We classify these market participants into three types: fully informed, partially informed and uninformed investors. We consider the portfolio optimization problems and compare the optimal trading and wealth processes for the three classes of investors theoretically and by numerical illustrations.